Risk Assessment

The uncertainty of the stock market has led many people to opine that "Wall Street" is little more than an air-conditioned racetrack.  If you think the analogy is apt, then you might view the mortgage industry as being akin to a Las Vegas casino.  Mortgage risk assessment is in essence little more than a series of carefully considered bets.  When a lender's underwriter approves a borrower for a loan, she (most seem to be women) is in effect, taking a bet that her firm will see their money again.  They are wagering on your character, your ability to repay the loan and your collateral.

The pricing for a mortgage (as with most everything in economics) comes down to a function of risk vs. reward.  The higher the risk, the greater the reward (interest rate) needs to be to offset the added risk.  Lenders are willing to make loans to those borrowers who fit in the lender's comfort zone based on their credit history, loan to value ratios (LTV), assets and reserves.  Obviously, the more favorable these things are the greater the likelihood that the loan will be repaid and consequently the lower the premium (interest rate) required to offset that risk.

Similarly, the more documentation that one can provide a lender, the less risky lending money becomes which is why stated income loans, low doc, no doc and no ratio loans cost more, again, because there is less to substantiate the certainty that the loan will be repaid.  Thus, the borrower pays for their non-disclosure or privacy.  The upside, however, is that these loans are easier to qualify for and theoretically should take less time to close because there are fewer documents required and fewer to be processed.

Understandably, lenders are concerned about protecting themselves against unforeseen risks (as would anyone lending money for 30 years into the future).  One of them is the risk of inflation.  To insure a degree of profitability, lenders making fixed rate loans charge more to offset the uncertainty of future inflation whereas with ARMs they tie the interest rates to certain indexes that adjust upward or downward as inflation rises or falls.

It would seem that with the lenders' risks carefully calculated that their profitability would be assured much like a Vegas casino's, yet one only need look at lenders' N.O.D.s [notice of default (foreclosure)] or the savings and loan debacle of the 80's or the sub-prime situation in '07 to realize that's not true.  In short, for lenders, mortgages are a game of chance.

Copyright 2020 Rod Haase.  All rights reserved.