Small-dollar mortgages are not as risky as most lenders think

Urban Institute digs into risk associated with this "missing piece of the mortgage market"

The purchase of a single-family home worth $70,000 or less is rarely financed by a mortgage, and while there are a number of reasons why, one major factor is their perceived risk.

A recent analysis by the Urban Institute examined the risk associated with small-dollar mortgages, determining that the perceived risk was “not correct or fair.”

But because many lenders shy away from offering financing on lower-valued properties, researchers said many creditworthy Americans are shut out of homeownership in low-cost or distressed communities.

According to the report, just 25% of homes purchased for $70,000 or less were financed with a mortgage in 2015. By comparison, 80% of homes valued between $70,000 and $150,000 were purchased with a mortgage.

Urban Institute’s report points to several reasons for this lack of small-dollar financing: fixed servicing and originating costs that make financing lower-value properties less attractive; all-cash investors who dominate low-cost housing markets; and the difficulty in securing a mortgage on manufactured homes of condos, which may comprise a solid portion of low-value properties.

Another key factor? Lenders’ perceived risk of small-dollar mortgages.

To determine if this risk was founded, the think tank examined the risk profiles of small-dollar loans to assess how they stacked up against larger loans. This is what researchers found:

Small-dollar loans have similar credit profiles
Small-dollar and mid-sized mortgages ($70,000 to $150,000) have comparable credit profiles across government, GSE, private-label securities and portfolio channels.

Loan-to-value ratios are also comparable between small and mid-size mortgages. Debt-to-income ratios for small-dollar mortgage borrowers are about 3 to 4 percentage points lower across all channels, which researchers attribute to lower monthly payments from lower loan balances.

Small-dollar mortgage loans perform like loans with higher balances
Minor differences in performance are explained by differences in credit score, DTIs and LTVs, Urban Institute stated.

For GSE and portfolio channels, small-dollar mortgages performed similarly and, in some cases, better than larger loans during the pre-crisis housing boom years, even though they had lower credit scores.

For the government channel, small-dollar loans had higher default rates in the pre-crisis years, but this has narrowed as the credit score gap narrowed.

The private-label securities channel had higher default rates overall, but during the 2005 to 2007 bubble years, small-dollar loans had similar or even lower default risk despite weaker credit profiles.

Loss-severity on small-dollar mortgages is higher
The loss severity for small-dollar mortgages originated from 1999 to 2017 was 61.6%, compared with 44.6% for loans on properties valued at $70,000 to $150,000.

Why? For one, fixed origination and servicing costs. Also, when a loan defaults, the loss severity is calculated as a percentage of the loan balance. Plus, losses on these loans are more likely to be written off to avoid the cost of loss mitigation.

But here, the institute points to something interesting:

Even though the greater loss severity on small loans is a symptom of the cycle of weak demand for small-dollar mortgages, it is also a cause, as the lack of such mortgages can depress home price appreciation and make it more difficult to recoup losses on the property. A more robust market for small-dollar mortgages could remedy this issue, as would implementing cost-efficient measures for originating and servicing small-dollar loans.

The researchers conclude that the practice of adding risk-price premiums to small-dollar mortgages is unfair, and that assumptions that they are inherently riskier are incorrect.

“There are hundreds of low-cost and distressed communities where affordable housing is available but not accessible to families who want to buy homes because the system for financing purchases is not robust enough,” the report stated.

Urban said a better understanding of how small loans perform can help lenders fill in this “missing piece of the mortgage market” and serve more borrowers.

“Otherwise, naturally occurring, affordable single-family housing will continue to be the province of investors and speculators who can buy homes with cash and will not be an option for the millions of credit-worthy potential first-time homebuyers and working families who could become homeowners if mortgage financing were available,” the researchers concluded.

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