In many communities across the U.S., small mortgages—those for less than $150,000—are largely unavailable despite an abundance of homes—and buyers—in that price range. Data suggests that the shortage of small mortgages drives some creditworthy borrowers to riskier, higher-cost alternative financing options, such as rent-to-own, contract for deed, and other seller-financing arrangements as well as personal property loans for manufactured homes. Others are left unable to buy, which compromises not only their residential stability but also their economic security and mobility by limiting their access to home equity, the largest source of wealth for most American families.
Alternative financing arrangements become more prevalent during recessions and are concentrated in communities with low home prices, limited mortgage lending, and higher vacancy rates. Although these options are governed by different state laws, they all typically have higher costs, fewer consumer protections, and less equity-building potential than mortgages.
The prevalence of small mortgages has decreased since the Great Recession. Between 2009 and 2018, the number of mortgages of $10,000 to $69,999 declined 38% and those for $70,000 to $150,000 fell 26%. By contrast, mortgages above $150,000 increased by 65%. In addition, an analysis by Urban Institute found that although small mortgage lending denials have risen since the last recession, poor creditworthiness among applicants was not the reason: Small mortgage borrowers’ credit profiles are similar to those of consumers who take larger loans. Further, when looking at people who are similarly creditworthy, small mortgage applicants were denied at a higher rate than prospective larger-balance borrowers.
In short, smaller mortgages are not inherently riskier to make than larger loans. But lenders are nevertheless reluctant to offer small loans, because market and regulatory forces disincentivize small mortgage lending. Specific factors include high fixed origination and servicing costs; similar regulatory requirements, regardless of loan size; insufficient appraisal data, particularly in lower-cost neighborhoods; and a compensation structure tied to the size of the mortgage—the larger the loan, the greater the commission—meaning that the amount of work required to issue and service a small loan is about the same as for a large one, but the return is much less.
Despite the regulatory and market barriers previously outlined, many banks continue to offer at least some mortgages of less than $150,000, and housing advocates have had some success encouraging mortgage lending in lower-income neighborhoods by invoking the Community Reinvestment Act or using public pressure. Further, some promising recent technological developments could help modernize underwriting in a way that makes safe small mortgages more attractive to lenders.
In particular, new, largely automated underwriting models augment credit reports with “cash flow data,” transaction information from a prospective borrower’s checking account and a review of rent, utility, and other routine payments that are not reported to credit bureaus. This approach helps reduce reliance on traditional manual reviews of pay stubs, tax returns, and other documents, reducing lenders’ expenses associated with the assessment of an applicant’s finances. Some evidence suggests that these procedures are at least as effective as traditional approaches in predicting borrowers’ likelihood of successful repayment. For instance, a recent FinRegLab report found that the cash-flow data approach is as good as traditional underwriting at identifying risk and enables lending to customers who lack a conventional credit score.
The COVID-19 pandemic has already caused financial disruptions for millions of Americans, and many more will probably face hardships in the coming months and years. Federal Reserve data shows that 40% of low-wage workers lost their job in spring 2020 and unemployment claims exceeded 40 million at the end of May. And even as Americans recover from these challenges, they may encounter high mortgage application denial rates unless lenders adjust underwriting standards to account for the impacts of the pandemic. This, and the structural characteristics that make smaller mortgages less profitable for lenders than larger ones, may prevent creditworthy households from obtaining financing to purchase a low-cost home.
Pew will be exploring the underwriting challenges that stymie the small mortgage market, possible strategies to improve access to reliable financing for creditworthy low-dollar borrowers, and the impacts on families that cannot get safe, affordable loans to purchase low-cost homes.
Alex Horowitz is a senior research officer and Tara Roche is a manager for The Pew Charitable Trusts’ consumer finance and home financing projects.
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