Why Is the Loan Rejection Rate Rising?
March 20, 2000, Reviewed February 4, 2011

"I have read that in recent years loan rejection rates have increased, especially among lower-income people and minorities…Why do they continue to get the short end of the stick?"

You are correct about the rising rejection rate. According to a recent Federal Reserve study, in 1993 lenders rejected 17.2% of all applications for conventional loans (those not insured by the Federal Government) for home purchases. In 1998, the rejection rate was 29.2%, an increase of 70% over 1993.

You aren't correct, however, in blaming lender prejudice against minorities. The rejection rate for white applicants increased by 70% between 1993 and 1998, compared to an increase of 58% for blacks and 54% for hispanics.

What then was the cause? When a housing finance system extends its reach to previously under-served groups, rejection rates invariably rise.

Some years ago I was on the board of a major lender that adopted a very aggressive program to reach out to lower-income households and minorities. We discovered that the greater our effort to find borrowers, the higher our rejection rate. Lower-income loan applicants had more credit problems than higher-income applicants, and minorities had more credit problems than whites.

Our rising rejection rate attracted attention from both regulators and community groups looking for bias. A high rejection rate is a red flag inviting unfriendly scrutiny. But there was little interest in the low-income and minority applicants we approved, who never would have applied without our outreach program.

Exactly the same thing happens when the entire system extends its reach down market. The 1993-98 period saw the remarkable growth of what is called the "subprime" market. In 1998, subprime lenders accounted for 34.1% of all home purchase conventional loan applications, compared to only 10.3% in 1993.

Subprime lenders offer loans to borrowers who don't meet the underwriting standards of prime lenders. The most common reason is that the applicant's credit score is too low, reflecting a poor payment record on past obligations. Other factors include a ratio of monthly housing expense to income that is well in excess of what lenders view as acceptable; excessive amounts of short-term debt relative to income; and the inability or unwillingness of applicants to document their income or assets.

While subprime lenders apply more liberal underwriting standards than prime lenders, they also have higher rejection rates. Since the subprime market has become a larger part of the total market than it was, overall rejection rates are higher.

The other side of the coin is the large number of approved loans to households who otherwise would have been shut out of home ownership because they couldn't obtain loans in the prime market.

Home ownership for the poorest households, those in the lowest 25% income bracket, rose by 6.2% between 1992 and 1998. Home ownership for those in the highest income bracket rose only 1.4% during the same period, according to the U.S. Census Bureau. By ethnicity, the home ownership rate increased by 4.3% for whites, 8.2% for blacks, and 12.0% for hispanics.

Certainly, everything is not peaches and cream in the subprime market. More subprime than prime borrowers are overcharged because more of them are unsophisticated, or don't shop, or both. In an earlier column, I suggested as a remedy that mortgage brokers be required to quote their prices in advance. This would eliminate most of the abuses in this market.

The price controls and other draconian restrictions that some state legislatures have imposed on subprime lenders is the wrong way to go. These restrictions shut out some borrowers from the subprime market, denying them home ownership.
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