Studies Support Risk Pricing, Prepay Penalties

The findings were from two studies authored by University of Virginia’s McIntire School of Commerce professors Richard F. DeMong and James E. Burroughs for the National Home Equity Mortgage Association.

While not necessarily surprising, “I think they’re very reassuring findings because they do suggest the marketplace is efficiently responding to the risk characteristics of borrowers,” Burroughs said Thursday during the opening session of NHEMAs compliance convention in Grapevine, Texas.

The most influential pricing factor is the FICO score, the analyses of more than 961,000 U.S. subprime loans said. On average, each 10-point increase in a borrower’s FICO score reduces the annual percentage rate on the loan by 10 basis points, or 0.10%.

Income is also a determinant. Borrowers with more secure income paid lower APRs than “stated income” borrowers, the announcement said.

Owner-occupied loans were an average of 62 BPS less than investor loans, NHEMA reported, while lower loan-to-values resulted in a 6 BPS decrease for every 10% in LTV.

The findings contradict those from another recent study by the Center for Responsible Lending, which suggested lenders have put borrowers into higher priced loans because of race, not risk factors. That report also said subprime purchase borrowers with prepayment penalties actually paid higher interest rates — about 40 BPS higher — than would otherwise be expected.

But NHEMAs analysis found that borrowers with prepayment penalties had APRs that were 38 BPS lower than those without them. While the benefit of prepayment fees weren’t affected by FICO scores, borrowers with higher FICO scores were found to be more likely to opt for a prepayment fee than those with lower scores.

“The analysis shows prepayment fees play a role in the marketplace quite different from what has been contended,” the authors said in one of the studies. Prepayment fees are used by individuals of all credit levels because the benefit of a lower APR more than offsets the relatively limited constraint of not being able to pay the loan off early.