Recent Urban Institute research has documented a lack of small-dollar mortgages for single-family home purchases. This shortage limits the opportunity for creditworthy families to find affordable homeownership opportunities in low-cost housing markets.
Almost 80 percent of homes valued between $70,000 and $150,000 were bought with a mortgage in 2015, but only a quarter of homes sold for $70,000 or less were financed with a mortgage. One reason for the shortage of small-dollar mortgages is that applicants for these mortgages face higher mortgage denial rates. Our most recent research shows that these higher denial rates have nothing to do with applicants’ creditworthiness.
The traditional measure of denial rates, the observed denial rate, compares the number of mortgage denials with total mortgage applicants for small-dollar mortgages (up to $70,000). This rate was 18 percent, or double the rate for large loans (more than $150,000) in 2017.
It’s not clear, however, why the denial rates are higher for small-dollar mortgages. Applicants for these smaller mortgages might have weaker credit profiles than applicants for larger mortgages. But if denial rates for smaller loans are higher simply because applicants for smaller loans have weaker credit profiles, the loan size is not to blame.
Alternatively, lenders might dislike the lower return on investment for smaller mortgages, which could lead to higher denial rates. But the traditional measure of denial rates masks differences in creditworthiness among applicants, making it difficult to determine whether weaker credit really is to blame.
By using a more accurate denial rate measure we developed, the real denial rate (RDR), we can control for differences in creditworthiness and better understand its role in the higher denial rates of smaller loans.
How did we find the real denial rate?
The RDR first divides owner-occupied purchase borrowers that apply for mortgages into two groups:
- High-credit-profile applicants (strong applicants that have virtually no chance of being denied a mortgage)
- Low-credit-profile applicants (weaker applicants who might be denied a mortgage)
Then, we compare the number of denials with just the number of low-credit-profile applicants, assuming that no one in the high-credit-profile group is denied a mortgage.
The real denial rate reveals creditworthiness is not the reason for the denials.
The RDR reveals that the creditworthiness of applicants for smaller loans is not the basis for the higher denial rate of these loans.
In fact, there is little variation in applicants’ credit profiles by loan size: the share of low-credit-profile applicants was 34 percent for loans up to $70,000, 35 percent for loans between $70,000 and $150,000, and 30 percent for loans more than $150,000. After controlling for applicant credit profiles, the gap in denial rates between loan sizes remains significant, varying from 29 to 52 percent.
The figure below shows that small-dollar mortgages are denied at higher rates than larger loans in both the government channel and the conventional channel. Small loans are denied in the conventional channel at 1.3 times the rate for larger loans and in the government channel at 2.09 times the rate for larger loans. But the conventional channel has higher denial rates overall.
Given the higher overall denial rates in the conventional channel, the overrepresentation of small loans in this channel is a significant factor in the higher denial rate.
Three primary factors contribute to the conventional channel’s dominance for small-dollar loan financing:
- Many small-balance conventional loans are in rural and low-cost communities traditionally served by small banks and credit unions, which tend to originate only through the conventional channel.
- Bank originators, who originate fewer government loans, must comply with Community Reinvestment Act (CRA) requirements to meet the needs of the communities in which they operate, including the needs of low- and moderate-income neighborhoods. Many of these small loans would “count” for CRA purposes, giving banks an incentive that can compensate for the higher fixed costs of originating and servicing small loans.
- Borrowers who make large down payments generally choose the conventional channel because it offers lower rates for borrowers with lower loan-to-value ratios. When a borrower in that channel makes a large down payment on a home in the $70,000-to-$100,000 range, that loan will fall into the smaller, under-$70,000 category, contributing to the prevalence of small loans. Similarly, when a borrower chooses the government channel to take advantage of the smaller down payment for a similarly priced home, the small size of that down payment will move the loan outside the “small loan” category.
Overall, we find that small loans are denied at higher rates than larger loans in both the conventional and government channels and that the characteristics of small loans contribute to their overrepresentation in the conventional channel, which generally has higher denial rates.
The high fixed costs of originating and servicing a loan makes smaller loans less attractive to lenders. We need further research on creative solutions to better serve this sector.