Friday, October 23, 2009

Shrewd Mortgage Borrowers Know Their PNPs

Posted on Yahoo Finance by Jack Guttentag:

In the mortgage market, PNP stands for "pricing notch point," which is a value of one of the factors used in pricing at which the price changes. In most lines of business, the factor used to price is the quantity purchased. For example, at the farm stand where I buy corn, the price is $.70 an ear for the first three ears, $.65 for the next three, and $.60 for any ears beyond six. This merchant’s PNPs are three ears and six ears. These PNPs are pretty easy for consumers to understand, but the stakes are small.

PNPs are more complicated, but the stakes are high. On a mortgage, the "price" includes the interest rate, mortgage insurance premium, and points, any or all of which can change in response to changes in loan size, loan-to-value ratio (LTV), and credit score. Each of these has its own PNPs.

As an example, on September 18, 2009, the interest rate on a 30-year prime FRM at zero points was 4.75 percent for a loan amount of $417,000, and 5.375 percent on a loan of $417,001. $417,000 was a loan-size PNP. On a prime 30-year FRM, the monthly mortgage insurance premium was .69 percent at an LTV of 85 percent, and .88 percent at an LTV of 85.1 percent. 85 percent was an LTV PNP. The same mortgage with a rate of 4.875 percent had points of .3 percent with a FICO score of 720, and points of .8 percent with a FICO of 719. 720 was a FICO-score PNP.

Since the increase in price that results from crossing a PNP applies to the entire loan, not just to the increment, the increment can be extremely costly. While no one would borrow $417,001, as in the above example, they might borrow $500,000. In that case, the cost of the $83,000 increment would be 5.375 percent on the increment, plus an additional .625 percent on the $417,000. The moral is that you don’t pass a PNP in the wrong direction if you can possibly avoid it.

Conventional Loans

On conventional loans, there are now two loan amount PNPs. One is $417,000, called the "conforming loan limit," which is the largest loan that can be purchased by Fannie Mae and Freddie Mac in any part of the country. The second PNP, called the “conforming jumbo limit,” varies by county up to $729,750 and is scheduled to expire at the end of 2009.

PNPs in the ratio of loan amount to property value are generally 80 percent, 85 percent, 90 percent, 95 percent, and 97 percent. In the crisis market that developed after the housing bubble burst in 2007, 75 percent also became a PNP.

PNPs often become relevant in connection with the issue of whether or not to finance closing costs, since doing so increases the loan amount and could breach a PNP. As an example, if closing costs on a $400,000 loan are $8,000 and the initial LTV is 80 percent to 83 percent of value, financing the closing costs won’t affect the price because the ratio will remain below 85 percent.

But if the initial LTV was 84 percent, adding the $8,000 would bring the ratio above 85 percent, raising the price on the $400,000. That would make the cost of the $8,000 astronomical.

Another Important Point

Another situation where PNPs are important to borrowers is where they have the capacity to make a larger down payment, or to pay down the balance preparatory to a refinance. If the larger down payment or prepayment penetrates a PNP, the return on investment will be very high. The financial crisis increased these returns by widening the price spreads between PNPs, and by eroding borrower equity.

As an example, a borrower who wrote me recently was paying 6.125 percent on her current mortgage and qualified for a no-cost refinance at 5.125 percent, which was highly advantageous. Because of the decline in the value of her home, however, her LTV had risen to 86 percent, which would require purchasing mortgage insurance on the refinance.

To avoid that, she would have to pay down the loan balance by enough to reduce the LTV to 80 percent. Relative to remaining with her current mortgage, I calculated the annual rate of return on the required investment at 18 percent over five years and 16.6 percent over 30 years, with no risk. Equally high returns are available on modest-size investments in partial prepayments that convert jumbo into conforming loans.

FICO-score PNPs may differ some from lender to lender, but they are equally important. A typical set would be 800, 780, 720, 700, 680, 660, 640, and 620. Mortgage applicants are much more likely to be on the wrong side of a FICO-score PNP than an LTV or loan amount PNP. They are less likely to know the FICO-score PNPs, and in many cases they don’t know their own score going in. Further, their loan provider may or may not be willing to put a deal on hold in order to work on an applicant's credit score. I will be discussing this issue in a future column.

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