Better borrower education before mortgage closings could have prevented some of the recession’s spike in defaults among low- and moderate-income homebuyers, the Federal Reserve Bank of Chicago concluded after studying marginal home loan recipients in Indianapolis for the last year.
Gene Amromin, a senior financial economist with the Fed, presented results of the study last week to the Indianapolis Neighborhood Housing Partnership Inc.'s board. INHP plans to release the results to the public this week.
“This wave of defaults reflects a vicious combination of a deep recession, a burst housing bubble and ill-advised financial choices by home borrowers,” the study reads. “These effects are particularly pronounced among the least creditworthy borrowers, many of whom became first-time homeowners in the heady days of the bubble. By one estimate, default rates on loans originated in 2006 by such ‘subprime’ borrowers approached a staggering 36 percent within 18 months of origination, as compared to 7.7 percent for the more traditional ‘prime’ borrowers.”
Founded in 1988, INHP is a not-for-profit that assists borrowers who have low incomes and checkered financial histories, teaching them key concepts of household budgeting, building their savings, repairing their credit records, and, ultimately, buying homes. Its rigorous program requires participants to graduate from a lengthy series of money-management classes and one-on-one monthly counseling sessions that continue for up to two years. INHP has an $8.8 million annual budget. Last year 1,715 households graduated from its education programs; 212 signed INHP loans.
With the help of Ohio State University and the U.S. Office of the Comptroller of the Currency, the Chicago Fed analyzed 211 borrowers who had worked directly with INHP between 2005 and 2007, then compared their mortgage default rates against the 16,677 total low-income borrowers who got mortgage loans in Marion County during the same period. The results showed a clear correlation between credit counseling and decreased defaults.
INHP’s clients had average annual incomes of $27,000, compared to $54,000 for the rest of Marion County. Their average FICO scores were 614, well below the 691 average for the entire county. And the INHP group borrowed less—an average $69,900, compared to $108,000 for the whole county. All INHP clients took 30-year fixed rate mortgages, compared to only 81 percent countywide. The rest entered some other form of mortgage loan.
After one year, the Fed found just 3.8 percent of INHP clients had defaulted on their loans, compared to 6.3 percent among the larger population.
“The effects [of pre-loan credit counseling] are strongest among households that appear least creditworthy in terms of their income and FICO scores, but who are granted credit on the basis of non-public (soft) information gathered during the counseling relationship,” the study reads. It goes on to point out that fraud is much less likely among INHP’s client population, since borrowers must work closely with counselors for an extended period of time. INHP’s borrowers also may be more disciplined, conscientious and thrifty than the general borrower population, according to the study.
“There is little reason to believe INHP clients, on average, experienced a different set of external economic shocks than similar non-treated households,” the study concludes. “Thus, counseled borrowers appear to have developed a sustained ability to maintain superior loan performance.”
In presenting his findings to the INHP board, Amromin pointed out that long-term borrower relationships also help lenders learn about mortgage problems long before they reach crisis proportions, giving the parties time to avoid defaults. And when times are tough, borrowers are much more likely to seek help if they aren’t scared of the lender’s reaction.
“People who get in trouble are terrified of conflicts with their lender, so they don’t get in touch until it’s too late” Amromin told IBJ. “INHP knows exactly what happens to each low-income individual. They’re doing what any good portfolio lender should do.”
The Fed will use its study as it considers broad policy decisions on whether to encourage more pre-loan credit counseling across the country, or to crack down harder on lenders who steer marginal borrowers toward mortgages they can’t afford. Amromin said the Fed will likely end up doing both, but finding the right balance is tricky.
Joe Huntzinger, the not-for-profit’s vice president of mortgage lending, said INHP now will attempt to disseminate the study results.
“We are pleased with the results of the research, because they confirm that INHP’s methods are effective,” he said. “We are planning to share this information as much as possible to advocate for the importance of education and mortgage and credit counseling ahead of homeownership.”
Local bankers are already scrutinizing the study to improve their own lending practices. Mike Newbold, regional president for Columbus, Ohio-based Huntington National Bank, said he’s “amazed” with INHP’s results, noting that a large proportion of the people who go through its educational programs end up learning homeownership is something they can’t yet afford.
“Frankly, I wish every one of our borrowers, regardless whether they’re low-income or not, could go through a program like that,” Newbold said.
More credit counseling could have prevented some of the worst banking practices that helped spur the recession, Newbold said. His industry is still reeling from the actions of lenders who let subprime borrowers enter adjustable-rate home mortgages, with little or no thought about what happens after a year or two when the rates move up and taxes start to kick in.
“One of the things that caused the nosedive in the housing markets nationally is the fact there were borrowers that frankly didn’t know what they were doing, and some lenders willing to take advantage of that,” Newbold said. “That same borrower could have potentially been a very profitable borrower and very responsible, if they’d understood what they were getting into.”