Literature Review and Introduction
A substantial body of research documents significant disparities in loan pricing based on the race, age, and income levels of neighborhood residents. These disparities result from discrimination, market failure, and other factors among minorities and the working class.[1] Discrimination and market failure impede wealth building and the creation of sustainable homeownership for residents of underserved neighborhoods.
Significant disparities in loan pricing reflect the growth of subprime lending. A subprime or high-cost loan has an interest rate higher than prevailing and competitive rates in order to compensate for the added risk of lending to a borrower with impaired credit. NCRC defines a predatory loan as an unsuitable loan designed to exploit vulnerable and unsophisticated borrowers. Predatory loans are a subset of subprime and nontraditional prime loans.[2]
A predatory loan has one or more of the following features: (1) charges more in interest and fees than is required to cover the added risk of lending to borrowers with credit imperfections, (2) contains abusive terms and conditions that trap borrowers and lead to increased indebtedness, (3) does not take into account the borrower's ability to repay the loan, and (4) violates fair lending laws by targeting women, minorities, and communities of color.
Lending discrimination in the form of steering high-cost loans to underserved borrowers qualified for market-rate loans results in equity stripping and has contributed to inequalities in wealth. According to the Federal Reserve Survey of Consumer Finances (FRSCF), the median value of financial assets was $38,500 for whites but only $7,200 for minorities in 2001. Whites had more than five times the dollar amount of financial assets than minorities. Likewise, the median home value for whites was $130,000 and only $92,000 for minorities in 2001 (Aizcorbe, Kennickell, and Moore 2003). By 2004, according to the FRSCF, the median net worth of minorities was 17.6 percent of that for all other families. In addition, the median net worth for African Americans was the same at $20,400 in 2004 as it was in 2001 ($20,300) (Bucks, Kennickell, and Moore 2006).
Since subprime loans often cost $50,000 to $100,000 more than comparable prime loans, a neighborhood receiving a disproportionate number of subprime loans loses a significant amount of equity and wealth. Using a mortgage calculator from Bankrate.com, a $140,000 thirty-year mortgage with the current prime rate of 6.25 percent costs about $862 a month, or about $310,320 over the life of the loan. In contrast, a thirty-year subprime loan with an interest rate of 8.25 percent costs $ 1,052 a month, or approximately $378,637 over the life of the loan. The difference in total costs between the 6.25 percent and 8.25 percent loan is $68,317. Finally, a thirty-year subprime loan at 9.25 percent costs $1,152 per month and $414,630 over the life of the loan. The difference in total costs between a 6.25 percent and 9 .25 percent loan is $104,310. For a family who is creditworthy for a prime loan but receives a subprime loan, the total loss in equity can be easily between $50,000 and $100,000. This amount represents resources that could have been used to send children to college or start a small business. Instead of building family wealth, the equity was transferred from the family to the lender.
Building upon this example, the equity drain from a neighborhood can be tremendous. Suppose 15 percent, or 300 families in a predominantly minority census tract with 2,000 households receive subprime loans, although they were creditworthy for prime loans (15 percent of families that are inappropriately steered into subprime loans is a realistic figure based on existing research). Further, assume that these families pay $50,000 more over the life of the loan than they should (the $50,000 figure is conservative based on the calculations above). In total, the 300 families in the minority census tract have paid lenders $15 million more than they would have if they had received prime loans for which they could have qualified. The $ 15 million in purchasing power could have supported stores in the neighborhood, economic development in the neighborhood, or other wealth-building endeavors for the families and neighborhood. For even one neighborhood, the magnitude of wealth loss due to pricing disparities and/or discrimination is stark. Across the country, the wealth loss is staggering and tragic.
In a study released in December 2003, “Broken Credit System: Discrimination and Unequal Access to Affordable Loans by Race and Age,” NCRC selected ten large metropolitan areas for the analysis: Atlanta, Baltimore, Cleveland, Detroit, Houston, Los Angeles, Milwaukee, New York, St. Louis, and Washington, DC. NCRC obtained creditworthiness data on a one-time basis from a large credit bureau. As expected, the number of subprime loans increased as the number of neighborhood residents in higher credit-risk categories increased. After controlling for risk and housing market conditions, however, the race and age composition of the neighborhood had an independent and strong effect, increasing the amount of high-cost subprime lending. In particular, the
• level of subprime refinance lending increased as the portion of African Americans in a neighborhood increased in nine of the ten metropolitan areas. In the case of home-purchase subprime lending, the African American composition of a neighborhood boosted lending in six metropolitan areas.
• impact of the age of borrowers was strong in refinance lending. In seven metropolitan areas, the portion of subprime refinance lending increased solely when the number of residents over 65 increased in a neighborhood.
In another study, “Homeownership and Wealth Building Impeded: Continuing Lending Disparities for Minorities and Emerging Obstacles for Middle-Income and Female Borrowers of All Races," conducted in 2006, NCRC found that racial disparities in the share of borrowers receiving high-cost loans were greater for upper-income borrowers than for lower-income borrowers across the nation. High-cost loans made up a high 41.9 percent of all refinance loans to LMI African Americans. In contrast, subprime loans were 19.2 percent of refinance loans to LMI whites in 2004. LMI African Americans were 2.2 times more likely than LMI whites to receive high-cost loans. Even for MUI African Americans, high-cost loans made up a large percentage (30.2 percent) of all refinance loans. Moreover, the subprime share of loans to MUI African Americans was 2.7 times larger than the subprime share of loans to MUI whites. The same phenomena of increasing disparities when income increased was observed when comparing high-cost lending in predominantly white and immigrant neighborhoods.
NCRC's findings are consistent with a wide variety of research on subprime lending. A study conducted by Freddie Mac analysts found that two-thirds of subprime borrowers were not satisfied with their loans, while three-quarters of prime borrowers believed they received fair rates and terms (Courchane, Surette, and Zorn 2002). Previously, Freddie Mac and Fannie Mae had often been quoted as stating that between a third to a half of borrowers who qualify for low-cost loans receive subprime loans.[3] The Federal Reserve Board (FRB) also released analyses of the 2004 and 2005 Home Mortgage Disclosure Act (HMDA) data revealing racial disparities even after controlling for income levels, loan types, and geographical areas (Avery, Brevoot, and Canner 2006). Immergluck and Wiles pioneered documenting the “hypersegmentation” of lending by race of neighborhood (Immergluck and Wiles 1999).
Calem, Gillen, and Wachter (2002) also used credit-scoring data to conduct econometric analysis scrutinizing the influence of credit scores, demographic characteristics, and economic conditions on the level of subprime lending. Their study found that after controlling for creditworthiness and housing market conditions, the level of subprime refinance and home-purchase loans increased as the proportion of African Americans increased on a census tract level in Philadelphia and Chicago (Calem, Gillen, and Wachter 2002; Calem, Hershaff, and Wachter 2004). The Center for Responsible Lending (2006) also used 2004 HMDA data with pricing information to reach the same troubling conclusions that racial disparities remain after controlling for creditworthiness.
- [1] Disparities discussed here reflect a number of factors, including income, wealth, credit rating, and many others. Discrimination, of course, remains a significant factor. Several studies discussed in this chapter have found that even controlling on credit-related factors, disparities persist. Disparities do not necessarily reveal levels of discrimination in the marketplace, but they do reveal the presence of ongoing barriers associated with socioeconomic factors.
- [2] A nontraditional loan is a loan that does not have a standard, fixed interest rate and/or does not have a traditional thirty-year term. An example of a nontraditional loan is an interest-only loan in which the borrower only has to make interest payments during a specified time period of the loan. An option ARM loan features a number of payment options; under one option, the borrower does not even have to pay the monthly interest that is due. A substantial number of subprime loans are nontraditional loans, but so are a significant number of prime loans. Option ARM loans, for example, are almost always prime loans.
- [3] “Fannie Mae Vows More Minority Lending," Washington Post, 16 March 2000, E01. See also, Freddie Mac Web page, freddiemac.com/corporate/reports/moseley/chap5.htm.
