LLPA: Loan-Level Pricing Adjustment in Regards to Home Loans
Getting a mortgage can be a stressful process-- and it’s not hard to understand why. Mortgages are generally the largest investments made by the average person in their entire lifetime. In fact, many believe that the huge financial burden that a mortgage creates is one of the main reasons why the leasing and rental industry has boomed in recent decades.
Mortgage loans are indeed incredibly large loans, with principal balances that literally take decades for the average person to repay. But besides a lengthy debt obligation, the cost of a home loan is one of the major things that drives fear into the hearts of home buyers. And to make matters worse, these costs come in two flavors, up front, and for the duration of the loan term.
It’s quite common for a potential borrower to be outwardly worried about the upfront costs of a mortgage transaction. In fact, it’s gotten to a point where the terms “closing costs” and “down payment” can be enough to send chills down a home buyer’s spine. Then again, with conventional home loans requiring a down payment of 20% of the principal balance, and closing costs as high as 5% of the principal balance, we don’t blame anyone for being worried. With the average home price in the U.S. sitting at around $200,000, producing 25% means that a borrower would have to come up with $50,000 during closing-- and that’s no easy feat.
But the thing is, once the upfront fees are taken care of, they’re gone -- for good. Mortgages can be incredibly expensive investments, but it is the amount paid over the life of the loan that really drains a home buyer. Lenders do not tend to pull punches when it comes to the interest charged on a mortgage.
While interest might be expensive, it isn’t necessarily unfair. The interest charged on a home loan is the cost of borrowing the principal amount, in other words, it is the compensation to the lender. Of course, loans are complex financial transactions, so where interest was once the major concern over a home loan, there is now APR -- an even more accurate representation of the cost of borrowing. APR, or annual percentage rate, combines a loan’s interest rate with other costs, such as broker fees and mortgage points, to give you a better idea of what you’re actually paying for your loan.
Regardless, a home buyer must learn to swallow those fears about the upfront fees and pay closer attention to the interest and APR rates that they are being charged. The average mortgage has a term of 30 years, and getting stuck in a loan agreement with a high interest rate will bleed a homeowner dry if they don’t wise up and refinance at some point. Lenders are well aware that the interest rate they charge is where the real money is coming from.
That being said, all home buyers need to know that the interest rate charged on a home loan is just as important to the lender as it is to the borrower. But, have you ever noticed how a quick comparison of any random three conventional mortgage advertisements may turn up similar low-end interest rates, only to find out that once the home buyer requests an official quote from any one of them, the actual rate that will be charged is much higher? It almost seems like false advertising on the part of the lender, and surely that’s bad for business, right?
Wrong. The interest rate that a lender charges each individual borrower is based on some incredibly important calculations that take many factors into consideration. Basically, the lender must assess the risk of loaning money to each borrower, in an attempt to determine whether it is worth it to do so, and how much they need to charge in order to make it worthwhile. The whole process is what is known as loan level pricing adjustment, or “LLPA”
What is Loan-Level Pricing Adjustment?
Mortgage lenders adjust their interest rates per borrower based on the presumed risk of loaning money to that borrower in a procedure known as Loan-Level Pricing Adjustment. This government mandated risk-based pricing is not entirely dissimilar to an auto insurance policy increasing rates for riskier borrowers. In general, the riskier the borrower, the higher interest rate they will be required to pay. Through loan-level pricing adjustments, lenders are able to legally charge more fees to borrowers deemed “risky” while not inflating the fees for their “safer” borrowers, who present less of a risk of defaulting on their mortgage loans.
Loan-Level Pricing Adjustment was first introduced into the conventional mortgage market back in 2008. When hundreds of government-backed mortgages went into default in what would become the biggest housing crisis of our era, the major mortgage superpowers of Fannie Mae and Freddie Mac realized that they needed a way to cushion themselves moving forward. After coming to the realization that their original stance left them both overexposed to risk and under-capitalized, they decided that they would need to charge greater fees.
Even with such a simple solution in mind, both entities were also well aware that an “across the board” inflation of fees wouldn’t exactly make conventional financing the most popular choice among home buyers. Instead, they needed a way to keep their rates reasonable for the less risky borrowers while maintaining the ability to charge higher fees to those borrowers who presented more of a risk. Loan-Level Pricing Adjustment was born from these ideas, as a way for the companies to raise the price of a loan based on the risk associated with each borrower.
The “price” of a loan, while most people tend to not realize it as such, is what is represented by the interest rate. Rather, the price of any particular mortgage loan dictates what the interest rate for that loan will be. A higher price means the borrower will have to pay a higher interest rate and a lower price means the borrower will have to pay a lower interest rate.
Loan-Level Pricing Adjustment allows mortgage prices to be adjusted by evaluating the different risk factors of any given borrower and basing their interest rates off of the assumed risk. This allows high-risk borrowers to be charged accordingly without penalizing the safer borrowers. Through LLPA, it isn’t rare for a borrower to see their mortgage price raised by over 100 basis points -- the equivalent of 1%. There are very few incidences when loan-level pricing adjustments aren’t imposed on conventional mortgage financing, namely when borrowers with credit scores over 720 are able to purchase a property with a down payment of at least 40%.
Risk Characteristics that Cause Loan-Level Pricing Adjustments
In order for loan-level pricing adjustments to take place, the lender must first assess a borrower’s risk. To assess a borrower’s risk, there are certain “risk factors” that lenders look for. When it comes to LLPA, there are over a dozen of these so-called risk factors, and almost all borrowers of conventional mortgages are affected by at least one of them.
LLPA risk factors also stack up, meaning the more risk factors the borrower is affected by, the higher the adjustment will be. Different lenders prioritize certain risks over others, but in general, the main risk characteristics that trigger loan-level pricing adjustments include (but are not limited to):
Loan amount (jumbo, conforming, etc.)
The level of documentation (Stated, limited, or full)
Loan purpose (refinance, investment, cash-out, home purchase, etc.)
Property type (multi-unit, manufactured, etc.)
Credit Score
Two of the most common pricing adjustments come from the loan amount (typically for loans over the conforming loan limit) or the credit score, which sees higher adjustments the lower the score. Almost as common are adjustments based on the loan-to-value ratio of a loan (based on the down payment a borrower is able to make) that is assessed based on LTV groups divided by LTV percentage range. Still, it is important to remember that these broad categories make way for more specific risk factors that lenders adjust prices for. Simple things like a cash-out refinance, regardless of the LTV, are subject to loan-level pricing adjustment solely based on the nature of the loan.
Other specific actions that typically trigger pricing adjustments include things such as getting a mortgage for an investment property, mortgaging a condo with less than 25% equity, subordinating a second mortgage through the usage of a piggyback loan, and even getting a mortgage to purchase a duplex or triplex. Loan-level pricing adjustments are partially to blame for borrowers needing to prove whether or not a property is being purchased for use as a primary residence, second home, or investment property. Primary homes carry the least risk, followed by second homes, which are only slightly lower risk than investment properties.
Even some opt-in benefits can lead to pricing adjustments. Borrowers who request rate locks or interest-only mortgages are also candidates for LLPAs. Home buyers who wish to avoid escrow accounts or “mortgage impounds” will be impacted by some adjustments as well. Even so, sometimes it is worth the higher rate to gain some flexibility in a mortgage transaction.
How Loan-Level Pricing Adjustment Affects a Mortgage
The first and most important thing to realize is that loan-level pricing adjustment is unique to conventional mortgage loans. LLPAs do not apply to government-insured mortgage programs such as FHA loans, VA loans, or USDA loans. They are fees that are assessed directly by Fannie Mae and Freddie Mac.
For borrowers who have multiple risk factors or pricing adjustments that make conventional loans unaffordable, it may be a wiser move to seek out a more affordable type of mortgage. This is why government-backed programs such as FHA mortgages are as popular as they are. One of the biggest risk factors for conventional financing is a borrower’s credit score, and FHA loans are willing to accept borrowers with credit scores as low as 500, which would be an extremely expensive venture (if even possible) through conventional financing methods.
One of the only conventional options that bends the rules a little is the HomeReady mortgage program by Fannie Mae. However, even the HomeReady program has LLPA limits that lenders must not surpass. It is one of the rare examples of conventional financing that could compete with the affordability of a government-insured mortgage product.
Still, in the overwhelming majority of cases, borrowers who choose conventional financing will have to deal with loan-level pricing adjustments. These adjustments aren’t as simple as fees added to your mortgage, either. In fact, there is as much going on behind the scenes as there is upfront when it comes to LLPAs.
While it may appear that loan-level pricing adjustments are fees directly charged to borrowers on their home loans, the actual process is slightly more complex. What truly occurs is that when LLPAs are imposed, Fannie Mae and Freddie Mac reduce the amount of compensation that they provide to lenders who sell them conventional mortgages. The inflated costs that borrowers are left with are a way for lenders to recoup this loss of compensation. Another way of looking at it is that LLPAs are the deductions to the fees lenders receive that are paid for by borrowers through higher interest rates.
In that respect, lenders typically do not suffer from loan-level pricing adjustments since they are able to charge borrowers higher rates in order to compensate for their reduced fees by passing those costs onto their borrowers. For example, a lender may receive a 1% standard fee as compensation for selling a conventional mortgage to Fannie Mae or Freddie Mac, which works out to $1,000 for a $100,000 loan. Let’s say that a loan level pricing adjustment of .300 is subtracted from the lender’s 1% fee, leaving them with only .700% or %$700 to receive as compensation for selling the loan. The lender needs only to increase the mortgage interest rates that they charge the borrower to make up for the loss of that $300.
Borrowers, in most cases, have no idea that loan-level pricing adjustment even exists, and in the long run, it doesn’t truly affect a prudent home buyer. After all, lenders are not required to disclose loan-level pricing adjustments, and the mortgage rates and closing costs that borrowers should already be paying attention to reflect the costs after pricing adjustments have already taken place. All loan-level pricing adjustments are standard between all lenders, but mortgage rates and closing costs are not. In the end, shopping around for better rates and loan terms is always the best course of action for a borrower.