Over the past decade and a half, first-time homebuyers have been increasingly squeezed out of the entry-level housing market. Many affordable homes are being sold to cash buyers or investors because prospective owner-occupants cannot obtain the small-dollar mortgages they need to buy them.

The problem lies in the nature of mortgage origination. Many origination costs are fixed; they are the same whether the mortgage is for $50,000 or $500,000. As a result, small loans cost much more to originate as a percentage of the loan balance, and these loans are much less profitable for lenders.

To help overcome this challenge, Congress recently authorized the US Department of Housing and Urban Development (HUD) to set up a pilot program to increase access to small-dollar mortgages under the 21st Century ROAD to Housing Act. If implemented effectively, this program could help remove barriers for first-time homeowners and help address the nation's ongoing housing affordability crisis.

Given HUD’s staffing constraints and the large number of programs and policies the agency is responsible for under the new law, a successful pilot will need to operate via systems already in place. We recommend it should both reduce fixed origination costs for borrowers where possible and provide a mechanism to provide incentives for lenders to make these loans.

Reduce the cost of appraisals and title searches

One strategy HUD could use to reduce the cost of originating small-dollar mortgages for lenders is to streamline two of the more expensive parts of the process: the appraisal and the title search.

Currently, most Federal Housing Administration (FHA) loans require a full FHA appraisal. The pilot could explore using less costly alternatives, such as an automated valuation model (AVM), a type of software that uses statistical modeling and data to estimate property values, or a broker price opinion (BPO), an estimate from a local real estate broker or agent. BPOs can either be an exterior-only “drive-by” assessment or include both an exterior and an interior inspection.

Both approaches have disadvantages compared with full FHA appraisals. Though AVMs are highly accurate overall, they tend to be less accurate in rural areas, which have a disproportionate share of less expensive homes. In addition, neither AVMs nor exterior BPOs do a particularly good job capturing property condition.

Interior BPOs could offer a useful middle ground, providing information about a home’s condition at a lower cost than a full appraisal. BPOs are already commonly used to price short sales and foreclosures and are used in some home equity underwriting processes, as the loans are much smaller.

Another way the pilot could eliminate costs for lenders is by accepting attorney opinion letters in place of a title search, which the government-sponsored enterprises already allow for both purchases and refinancing. To issue an opinion on the status of the title, an attorney researches property records and outstanding liens. Unlike title insurance, however, attorney letters do not provide the same indemnification if a title problem is later discovered, leaving the FHA with a small amount of residual risk.

These changes could reduce the cost of making small-dollar mortgages and could pave the way to streamline costs on all mortgages—a potential boon to all prospective buyers amid a national housing affordability crisis. But reducing costs is only one side of the equation. To increase its potential impact, the small-dollar mortgage pilot should also provide incentives for lenders to originate small loans.

Incentivizing lenders to originate small-dollar loans

To encourage more lenders to make small-dollar loans, HUD could model its pilot on the Illinois Housing Development Authority’s (IHDA’s) successful Access Plus program (PDF). Launched in 2022, Access Plus provides lenders in the state a flat $5,000 stipend—or Service Release Premium—for each eligible mortgage of $60,000 or less. The IHDA set the $5,000 incentive to approximate the compensation a lender might receive from a typical 2 percent Service Release Premium on a much larger mortgage (roughly $250,000).

Access Plus has facilitated 264 mortgages totaling more than $11.7 million. The average borrower has an income of approximately $39,400 and a credit score of 707, and the average home purchased through the program costs approximately $53,680. Though the program remains small, it provides a useful proof of concept for the idea that compensating lenders directly for making loans that would otherwise be uneconomic would expand access to small-dollar loans.

Equally important is how the IHDA delivers the $5,000 incentive to lenders. Access Plus operates through the agency’s existing network of approved mortgage lenders and applies to standard government-backed and conventional loans lenders already know how to originate. There’s no separate Access Plus approval process or application; when an eligible mortgage of $60,000 or less is delivered to the IHDA, the additional payment is triggered automatically.

Because the fixed expense of origination is one of the main barriers to small-dollar lending, operational simplicity is crucial for any solution HUD pursues. A program that asks lenders to devote time and staff to learning a new workflow or completing additional paperwork risks re-creating the same problem it is trying to solve.

With proper implementation, a small-dollar mortgage pilot could help expand financing options for first-time homebuyers

A successful small-dollar mortgage pilot could help give more first-time homebuyers the opportunity to buy entry-level homes that are currently being sold to cash buyers and investors.

But the pilot’s outcomes are critically dependent on its implementation. Reducing fixed origination costs where possible and providing incentives for lenders to make these loans using systems already in place will minimize the work for HUD amid capacity constraints and will maximize lender participation.