Will Higher Mortgage Rates add to Loan Default Risk? Refi Credit Scores Dip 9 points For Each Half-Percent Rise in Mortgage Rates

Mortgage rates have risen since last summer to their highest level in two years.  Let’s explore how higher mortgage rates may affect the default risk of loans currently outstanding, as well as new originations.

Higher interest rates can lead to an increase in monthly payments on adjustable-rate mortgages, also called ARMs, and this “payment shock” can add to delinquency risk.  But there are at least four reasons why higher rates are unlikely to have much effect on overall home mortgage default. 

First, adjustable-rate loans account for about 7 percent of loans outstanding, and these tend to be high-balance loans made to borrowers with higher income and wealth and who are in a better financial situation to accommodate payment increases. (Figure 1) Second, since a large majority of long-term fixed-rate loans have contract rates below current market rates, the market value of their loan balance declines when market rates move up, reducing their effective loan-to-value ratio.  Third, about one-fourth of all home loans are fixed-rate with terms of 15 or 20 years, which amortize more quickly than longer-term loans.  Fourth, higher mortgage rates are often accompanied with higher inflation, meaning that home-price growth will help build home equity and push loan-to-value ratios lower.

And how will higher rates affect the credit risk attributes of new originations?  We are likely to see somewhat lower credit scores for new borrowers as rates move up, especially for refinance. 

In the past, when rates have risen applications drop off and loan officers spend more time with the applicants that require ‘special handling’.  These refi’ers are still investment quality, but may require more documentation, have unique property issues, or less-than-pristine credit scores.  (Figure 2) Since 2009, for every one-half percentage point increase in mortgage rates, the average credit score on refinance borrowers has dipped by 9 points, and this pattern will likely continue if rates move higher.[1]

In summary, the effect of higher mortgage rates on default risk of loans outstanding is ambiguous, but the effect is probably small.  For new originations, some credit risk attributes may look more risky as lenders invest more time with harder-to-qualify applicants, but that does not mean that lending standards have necessarily eased.

CoreLogic.com