Providing small mortgage loans at non-subsidized prices affordable to the borrower has always been a challenge. The core problem is that the high cost of originating and servicing a mortgage loan is no smaller for a small loan than for a large one, but the dollar amounts of interest and origination fees received by the lender are smaller on small loans. The obvious remedy, charging a higher interest rate or upfront fees on smaller loans, may make it unaffordable, may be interpreted as “price-gouging,” and may invite the attention of regulators.
Home mortgage lenders prefer to avoid these problems by setting minimum loan amounts, which today are generally in the range of $50,000 to $75,000. Below $50,000, mortgage loans are generally not available. This is a problem for isolated communities in which home prices are very low, and also for borrowers anywhere who are looking to refinance small loan balances.
THE PROBLEM OF THE SMALL ISOLATED TOWN
“In my town, we need mortgage loans from $5,000 to $30,000, and they just aren’t available. Is there anything that can be done?”
The town is Winters, Texas, population about 3,000. There are few jobs there or anywhere very close, and median household income is about $26,000. Houses in Winters sell for less than $60,000.
Mortgage loans are not available in Winters. In part, this is because the town is so isolated and the demand so small that it can’t support a lending facility. There are no appraisers, for example; if one is needed the cost will be double the cost in a larger center because of the time it takes for the appraiser to get to Winters and back.
The combination of exceptionally high origination costs and exceptionally small loan amounts is deadly. The best option for residents of Winters who need funding is an unsecured loan, as discussed below.
THE PROBLEM OF REFINANCING SMALL LOANS
Another category of borrowers who are potentially vulnerable to the small loan problem are those who have paid their loans down substantially and would like to take advantage of lower interest rates by refinancing.
“I have a 10 percent loan from way back, should have refinanced years ago, balance is only $42,000 now, is it too late?”
Yes, it is too late. No lender wants to refinance a $42,000 loan into another $42,000 loan. The exception would be the case where the borrower wants to raise a substantial amount of cash from the transaction, which means that the new loan amount will be substantially larger than the balance of the old loan. In that situation, there is no small loan problem because the loan is not small.
SMALL UNSECURED LOANS THROUGH THE INTERNET
When I wrote an early version of this article in 2007, www.Prosper.com was a new firm chartered to create a virtual market that provides an attractive return to lenders and a reasonable cost to borrowers. Lenders are given extensive information about borrowers, including credit information and referrals. They can lend as little as $100 on any one deal, which allows them to diversify their risk without committing larger sums. Because it is a virtual market, borrowers can live anywhere, even in Winters.
Prosper charges a reasonable origination and servicing fee for doing all the spade work: compiling borrower information, collecting the payments, keeping the books, and pursuing delinquent borrowers. In the first quarter of 2015, Prosper closed $595 million of loans, with a total to date of more than $3 billion.
Loans from Prosper are too small ($35,000 max) and too short (5 years max) to be used for a house purchase, except perhaps in places like Winters where home prices are very low and mortgage loans are not available. In the 1920s, before the Federal Government entered the marketplace, many mortgage loans had 5-year terms.
THE PROBLEM OF SMALL REVERSE MORTGAGE LOANS
Lenders originating HECM reverse mortgage loans earn income from two sources. An origination fee based on property value is capped by law: it is $2,500 on house values of $125,000 or less, $4,000 on a house value of $200,000, and $6,000 on values of $400,000 or more. The other source of income to originators is the premium paid for the loan in the secondary market, which can run as high as 8 percent of the loan amount, as contrasted with 4-4.5 percent in the standard mortgage market. However, reverse mortgage originators earn the premium only on the initial loan; they make nothing on cash draws that occur after the loan closes.
The small loan problem for originators is that they don’t make much on transactions in which the borrower wants only a credit line for future use because the initial loan in such case consists solely of the financed settlement costs. Some lenders may refuse to make such loans, but others will because they still earn the origination fee.
Borrowers in this market have a small loan problem if they are planning to save their reverse mortgage borrowing power for future use rather than drawing cash at closing. The problem is that this forward-looking game plan of borrowers runs counter to the financial interest of their originators. The originators I know are scrupulous in not pushing borrowers to draw more cash, but expecting them to discourage borrowers from drawing cash is not realistic.
ABOUT THE WRITER
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
©2015 Jack Guttentag
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