What is Credit Score Compression?

What is Credit Score Compression?

Both Fannie Mae and Freddie Mac use risk-based pricing for every loan they purchase. Risk-based pricing, at its most basic, is determined by each loan’s loan-to-value (LTV) ratio and the borrower’s credit score. Generally speaking, the higher the credit score and the lower the LTV, the higher the price Fannie and Freddie pay for the loan. Lenders that sell to Fannie Mae and Freddie Mac are familiar with this risk-based pricing approach through the Loan Level Pricing Adjustment (LLPA) matrix published by both entities. During the peak of the 2020/2021 refinance cycle, most lenders were passing on this pricing advantage to borrowers with higher credit scores in the form of lower mortgage rates. This practice of passing on this benefit appeared to end in late summer/early fall of 2022. We see this as a form of credit score compression; credit scores became irrelevant in terms of delivering a pricing advantage to borrowers, this despite the fact that Fannie Mae and Freddie Mac continue to offer a risk-based pricing advantage to lenders. Lenders benefit when their borrowers have a higher credit score. Borrowers don’t benefit, regardless of credit score, thus credit score compression.

Here’s what happened in 2022.

While wrapping our heads around the state of the mortgage market and where it’s headed this year, we wanted to check in on rates and the impact credit scores have on them.

We first noticed in September 2022 that lenders were not passing along the advantage higher credit scores afford lenders vis a vis the Fannie Mae/Freddie Mac loan level price adjustments (LLPA). It’s important to note the LLPA matrices have not changed since last year. Not passing on the advantage to the borrower is likely because lender revenue has fallen significantly, including secondary market revenue. According to the Mortgage Bankers Association’s regular reporting on lending performance and profitability, the secondary market income in the third quarter of 2020 was $10,833 per loan. In 2022 it dropped to $7,165 per loan. Retaining the price advantage that the LLPA matrix affords helps lender’s shore up profits.

Here’s why we think this is important.

• Lenders aren’t passing on the advantage of a higher credit score to borrowers.
  Part of the market isn’t functioning as it did during the 2020/2021 refinance cycle. One of the key tools CreditXpert has identified is value to the borrower of increasing their credit score thereby reducing their mortgage rate. While lenders should be passing on the advantage of a higher credit score to borrowers, they’re retaining it, as mentioned previously, to offset missing secondary market revenue.
• Lenders should be working with borrowers to better their credit score.
  Even though there’s little current advantage to the borrower, the advantage to the lender remains unchanged: the higher the credit score, the better the price for the loan as detailed in the LLPA matrix. Lenders need borrowers with higher credit scores so that they get the highest possible price for their loans so that secondary market profits level off or increase. Doing so helps to offset the $3,688 drop in secondary market income lenders are experiencing now.

When will credit score compression end?

Credit score compression will end at some point when the cost-to-produce a loan decrease below its current all-time high of over $11,000 per loan and when secondary market revenues stabilize. Lenders can and should, however, pass along the pricing benefits of higher credit scores to borrowers when competitive situations dictate the need.  Remember: borrowers choose their lender first based on rate, second on payment (which is really the same thing) and third on relationship. Offering lower rates for higher credit scores is one of the ways lenders can thrive in 2023’s evolving market.