Default rate to interest rate ratio
Curious if there is a rule of thumb for expected default/delinquency rate of the borrow relative to the interest rate on the loan sold to the borrower.
Specifically, I'm looking to answer this hypothetical: If one could ensure a lender that one could reduce default rate by x%, what reduction in interest rate could the lender provide in return?
e.g. 2015 had abt a 5.5% delinquency rate. If a lender knew that the pool of borrowers could be reliably lowered to 4.5%, what interest rate discount would occur in exchange?
It's an interesting question you pose, but in practice interest rates are set by supply and demand between borrower and lender. That balancing point is established through countless tens of thousands of daily transactions and is impacted by lender competition, the index rate, economic cycles, real estate cycles, credit scores, and, yes, default rates.
Now, with single family real estate mortgages, rates are in part set by default expectation based on credit scores and down payments. However, I don't believe a default rate spread is neatly priced into the interest rate in a rule of thumb. For large lenders, their treasury department senior personnel are making daily/hourly decisions based on the sum total of all known factors, balanced by the need to produce interest revenue in a competitive lending environment.
I'll add that I believe default loss rate is probably a more critical factor in determining interest rates than delinquency rate. But I'm not 100% sure on that.
Thanks for the reply.
i understand the supply/demand aspect. Credit worthiness clearly does impact interest rate from the borrower's perspective -- If I have credit score 780 my rate for a same sized loan will be lower than someone with credit score 480.
I am primarily interested in SFH mortgages and non commercial real estate.
Accepting that yes there are many more factors besides default rate that determine price a given mortgage, if one could keep other traditional factors (index rate, economic cycles, credit scores, etc.) constant while ensuring a lower default rate then we are looking at a lowered interest rate in return, yes?
If yes, what is the expected relationship?
I mean, that's a great question you're putting forth. Keeping all factors constant, what is the impact of default expectation on interest rate for SF mortgages?
I've got a friend who is a higher up at a very large mortgage lender--I'll ask him and see what he understands about that process.
To follow up on this, my friend broke it down for me.
Basically, there are credit thresholds every ~20 credit score points. For example, there is one between 681 and 700, 701 and 720, 721 and 740. Each hurdle is worth about 25 basis points in pricing, all other factors remaining equal. So the answer to your question is 25 basis points is a rule of thumb (although it's not necessarily hard-and-fast--it can sometimes be 12.5 bps or even 50 bps). Also, you won't necessarily see a 25 bps change in interest rate. The price movement is sometimes applied partially to interest rate, partially to rebates, and is sometimes withheld by the bank totally or in part. That's where the "negotiation" begins and where the best informed clients often get best pricing.
At quod necessitatibus vel. Quam voluptas ducimus ut consequatur.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...