How to make small-balance mortgage lending profitable

The percentage of smaller-balance mortgages compared to their larger counterparts continues to shrink, declining by 70% between 2004 and 2021, and that particularly affects Black, Hispanic, indigenous and rural families, a report from the Pew Charitable Trusts found.

The report defines a small-balance mortgage as a loan at or under $150,000.

Lenders have trouble making a profit with these mortgages as most of their costs are fixed. The revenue earned grows with loan size. "And so, lenders make a lot more on a million dollar mortgage than they do on a $100,000 mortgage but those costs are almost the same," said Alex Horowitz, project director of the Housing Policy Initiative, and co-author of the report, follows a 2022 paper from Pew.

Instead of getting a traditional first mortgage, many of these homebuyers are forced to turn to alternative financing sources, including contract for deed, rent-to-own and personal property loans for manufactured homes. 

While a Javelin study found interest in the rent-to-own option is growing among younger consumers, those can also be predatory, regulators have warned. In fact, one company, Vision Property Management faced allegations of predatory lending in several states, including New York.

Meanwhile, both Fannie Mae and Freddie Mac have committed to conduct pilots for chattel financing of manufactured homes as part of their duty-to-serve plans.

Between 2018 to 2021, about 5.3 million homes were sold for less than $150,000. In the counties that Pew examined, only a quarter of low-cost sales are being recorded with a mortgage, but just 3% of first-time home buyers are using cash.

"There's a real problem here and policymakers can help," Horowitz said. "We don't know all the answers, but we wanted to quantify the problem and emphasize that this is important."

For example, the Home Ownership and Equity Protection Act sets thresholds for what is considered a high-cost loan and puts restrictions on points and fees and whether or not a loan meets the qualified mortgage test. In Pew's research, lenders did identify HOEPA as one reason why they stay away from small-balance mortgages, Horowitz said, adding "that may be one piece of the puzzle…but we're confident that's not the only factor at play," referring to the revenue factor.

In fact, the Consumer Financial Protection and the rules put in by the Dodd-Frank Act have worked as intended because they chased away the bad actors, said Rob Zimmer, who does external affairs for the Community Home Lenders of America.

"But by its very nature once you standardize things to protect consumers, including putting a percentage cap on production fees, you are going to rule out small-balance mortgages unless you have an exception to that," Zimmer said.

If the regulators in Washington were willing to make changes in order to facilitate small-balance lending, it is likely the situation would improve.

"It can't say the framework is the framework, just find a way to make it happen," Zimmer said. "Because it's just not going to happen given the fixed costs of producing a mortgage."

In December, the CHLA sent a comment letter to the Federal Housing Administration recommending that the Department of Housing and Urban Development set a percentage definition for a small balance loan, at 80% of the county median, rather than a flat amount. That would include more areas, especially urban markets.

Concurrently, they recommend a 6% cap on points and fees for FHA mortgages between $60,000 and under $80,000 and a cap of 5% for loans between $80,000 and under $100,000. QM currently has a flat $3,000 point and fee limit. 

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Allowing larger compensation on these loans, Zimmer admits sounds "kind of counterintuitive, because some lay people in D.C. will say 'that's outrageous, why should you make more money on a percentage basis on a small balance mortgage.' But again, it's just the economic reality." 

Other comments in the letter included aligning the FHA 203(k) program standards with those of a similar Fannie Mae program, Zimmer pointed out.

It's not just the secondary market revenue that is based on the balance. At the vast majority of mortgage companies, the loan officer commission is also a percentage of the amount borrowed.

The Neighborhood Assistance Corporation of America is both a Department of Housing and Urban Development-approved counselor as well as mortgage broker.

It offers the Best in America Mortgage, a no down-payment, no closing costs, no fees, no mortgage insurance loan, at a below market fixed-interest rate without consideration of credit score.

It gets a flat fee of $3,500 from the lender for the loan, explained Bruce Marks, CEO. A commission structure disincentivizes originators from doing small-balance mortgages, he continued, noting he agreed with Pew's findings. The majority of his company's loans are in the range Pew cited as problematic.

NACA pays the real estate brokers it works with a flat fee as well. "It's never a percentage and that's the way it should be," Marks continued. "Our system is set up to incentivize lending to higher income people…and to put roadblocks into lending to lower income homebuyers who will be purchasing at a lower purchase price."

And it completely flips the script on loan officer compensation.

"While we get paid the same amount from the lender, the way that we compensate our staff is that if they're [working with a]  low to moderate income [borrower], they will get twice as much when they close a loan than if [the borrower is] higher income," Marks said.

NACA just completed a five-day Achieve the Dream event in Newark, New Jersey, which also included, with the cooperation of the city and Mayor Ras Baraka, properties available for $1.

To Marks, one simple solution from the regulators, particularly the Office of the Comptroller of the Currency during fair lending audits to reverse the disincentives in the market for making smaller-balance residential mortgages, particularly in terms of compensation.

The Pew survey estimated about 36 million Americans have used some kind of alternative financing at some point, including about 7 million currently in such arrangements because of the lack of access to small mortgages. 

"There are parts of the country where somebody's mortgage payment is lower than their rent or would be lower than the rent," Horowitz said. "If somebody can handle $1,200 a month [in rent], they can almost certainly handle $800 for a mortgage payment."

Thus these consumers would be better served if they can get a traditional mortgage. "But lenders have trouble originating those loans profitably, so policymakers should prioritize this," Horowitz said. "It doesn't make sense that somebody's paying a lot more for rent than they would for a mortgage if they want to be a homeowner."

However, Horowitz did note that loan manufacturing costs have tripled since 2009. The answer might be using more technology in the process. He noted that other forms of lending have not had the same increase in costs that the mortgage industry has seen.

"It's worth doing a deep dive here and seeing if there's a way to turn back the increase in the cost to originate without turning back consumer protections," Horowitz said. "Is it possible they can have the same level of safety while enabling more streamlining?"