For some lenders, delinquency rates in special lending programs are consistently higher than for conventional loans. Yet good performance on affordable mortgage products is vital to the long-term success of these programs.
National studies have shown that very small down payments, coupled with limited monthly reserves and past credit problems, can lead to higher delinquency levels on home mortgages. The central issue isn't the trend toward higher delinquency. The focus should be on reducing this rate, because we must continue to serve this home ownership market.
One possible answer comes from Battle Creek, Mich., a small industrial city recovering after years of decline. City leaders, local lenders and residents are restoring older neighborhoods through innovative strategies that rely heavily on special lending programs.
The strategies involve large-scale initiatives to demolish abandoned buildings, repave streets, repair substandard houses and attract new businesses and institutions. The principal strategy emphasizes lending for home purchase and for home repair. In less than five years, Neighborhoods Inc. has made more than 700 loans that have helped create more than $10 million in direct investment. These loans have significantly increased the percentage of home ownership, while creating higher standards for home maintenance.
With lending at its core, good loan performance is critical. Local leaders decided to build good performance into the design and delivery of loan products. To accomplish this, my staff and I committed ourselves to flexible but sound underwriting and to seven principles for reducing delinquency:
1. Maximize the buyer's responsibility.
It isn't beneficial to hold a buyer's hand through every aspect of the purchase. Each borrower needs to work hard to buy if ownership is to be valued. Neighborhoods Inc. expects borrowers to resolve their own credit problems, to track down missing records, and to establish and follow a good day-to-day budget. Neighborhoods Inc. also tries to include some modest sweat equity, so home buyers develop a stronger sense of personal involvement.
2. Prepare customers to make sound choices.
If counseling starts after the signing of a purchase contract, we have lost the best opportunity to help buyers. Buyers need to think through whether home ownership is right for them, what features the house should have now and for resale later, and what role the neighborhood plays in the purchase decision. Because lower-income buyers don't have as many choices, helping them make a well-considered one is even more important.
Higher-priced houses usually benefit from more active real estate agent involvement in the education process. We need to build the same training investment into the purchase of more affordable properties.
3. Remind borrowers they are buying a house and a neighborhood.
Encourage informed buyers to study the dynamics of the local real estate market. Borrowers need to analyze trends in the neighborhoods. A home purchase isn't done just to acquire good housing; it is a major investment and should show equity growth. An attractive house in a neighborhood of declining value usually ends up on an economic sidetrack. The resulting frustration can undermine good payment behavior.
4. Promote the goal of being "house proud."
Being proud of one's home is a powerful impetus to action. Affordable housing programs that only bring houses to a code-compliant condition may undermine a sense of pride in ownership. We've never met the buyer who proudly points to a house as meeting minimum standards. Home buyers need to feel their homes are special: an oversized kitchen, a gracious porch, or even just an outstanding paint job. If borrowers face some tough payment decisions, pride in the home is a compelling force to assure we get paid.
5. Provide counseling about the decision to buy, not just about the process of buying.
Deciding about buying a home and committing to pay the mortgage on time should be the focus for counseling. The mechanics and jargon of buying--title searches, right of recision, the distinction between a note and a mortgage--are important only if the fundamental decision to borrow is a sound one.
Too often a loan is approved contingent on reading a home-buying guide or attending a class. Yet much of what is learned will soon be forgotten. The important lesson: when borrowers know why they are buying, they will know why it is important to pay.
6. Structure financing as close to conventional as possible.
Even when Neighborhoods Inc. was involved in financing, we made every effort to place part of the financing with a conventional lender. Because most special programs are for people with a deficiency--too little down payment, insufficient earnings, shaky credit--these lending programs might imply a second-class status. We need to mitigate this by showing that a conventional lender is enthusiastic about taking on part of the loan. Having a nonprofit agency approve your loan is one thing; having a bank approve it is quite another. Reinforcing a standard bank relationship will strengthen the borrowing and lead to a long-term customer who pays.
7. Continue a positive relationship after closing.
In most conventional loans, lenders pay close attention to borrowers at purchase or at delinquency. This is reasonable. However, in a truly comprehensive affordable-lending program, the borrower is critical as an ongoing element in the neighborhood.
Committed, enthusiastic home buyers encourage others to buy a home and reinforce current homeowners who are considering property improvements.
A borrower committed to the neighborhood is more likely to be committed to loan repayment. Therefore, a good counseling program keeps an ongoing relationship with the borrower and encourages involvement in the community. There is a positive relationship with the counselor if payments become a problem.
Do these principles pay off? I believe they do. Of course, good underwriting is critical to a good loan, but delinquency control also must be built into every aspect of the purchase and mortgage process.
Is Neighborhoods Inc. pleased with the results? No. At any given time, troubled loans account for 2 percent to 3 percent of the group's portfolio. This is unacceptably high for a conventional lender. For a nonprofit organization lending to buyers who don't qualify for conventional lending, Neighborhoods Inc. expected higher percentages.
However, expecting higher delinquency and accepting poor loan performance are not the same thing. Neighborhoods Inc. continues to work hard to strengthen performance, not just to guard its portfolio or its borrowers, but to protect neighborhoods.
In today's highly competitive business environment, most lenders can't reasonably attempt the sorts of initiatives used every day by Neighborhoods Inc. Fortunately, most lenders have a relationship with a similar nonprofit already. What is absent isn't the opportunity but the expectation that nonprofit groups set high performance standards and meet those standards.
It is far too easy for both nonprofit groups and conventional lenders to accept poorer performance from special lending programs. The challenge is to set higher goals and then to structure the programs and resources to attain the goals.
Keep up with what’s new and noteworthy at the St. Louis Fed. Sign up now to have this free monthly e-newsletter emailed to you.