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February 08, 2005
Academic Study Links Predatory Lending to Increased Risk of Foreclosure
by William Baue
Prepayment penalties increase the risk of foreclosure by 20 percent, while balloon payments raise
the risk to almost 50 percent, according to the University of North Carolina study.
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Although it may seem like a no-brainer that predatory lending terms would increase the risk of
mortgage foreclosure, empirical evidence on the link was lacking until recently. Late last month,
the Center for
Community Capitalism at the University of North Carolina (UNC) released a study finding
that prepayment penalties and balloon payments raise the risk of subprime loan foreclosure. The
study even controlled for other potential contributing factors, such as borrower's credit score,
loan terms, and varying economic conditions. The findings bolster socially responsible investment
(SRI) and community investment advocates' opposition to predatory lending.
"The
study demonstrates that subprime prepayment penalties and balloon payments place Americans at
substantially greater risk of losing their homes," stated Michael Stegman, director of UNC's Center
for Community Capitalism and study co-author with Roberto Quercia and Walter Davis. "Given the
significant financial and emotional costs associated with foreclosure on families and
neighborhoods, policymakers should take note."
While subprime lending can benefit
borrowers with blemished or limited credit histories by giving them access to credit (at higher
than prime interest rates to compensate for the higher risk), predatory subprime lending adds costs
or default risk with no counterbalancing benefit. Predatory lending is based on "deceptive and in
some cases illegal practices to coerce borrowers into unfavorable mortgage agreements," according
to the report.
"Data suggest that low-income, elderly, and minority borrowers may be
especially vulnerable to this type of lending because of their greater susceptibility to 'push
marketing,' high-pressure sales pitches, lack of experience with mortgage lending, and urgent need
for credit," states the study.
Two practices associated with predatory lending are
prepayment penalties, which prevent refinancing when interest rates fall or credit records improve,
and end-of-loan balloon payments that exceed a borrower's ability to pay, forcing yet another
refinancing and a new round of fees. While several recent studies have advanced the common-sense
notion that such predatory practices increase the risk of foreclosure, the UNC study is the first
to provide empirical evidence.
The study examines data licensed from a large private
database of securitized subprime loans: 3,763,713 monthly observations from 122,456 first-lien
refinance loans of owner-occupants nationwide originated by retail lenders in 1999, with the study
period ending in December 2003. The study establishes the explosive growth of subprime loan
originations, increasing nine-fold between 1994 and 2003, from $35 billion to $332 billion.
Prepayment penalties with terms of three years or longer increase the odds of entering
foreclosure by 20 percent compared to loans without such penalties, and balloon payments increase
foreclosure odds by 46 percent compared to loans without balloon payments. The study also notes
that adjustable rates in subprime lending raise the risk of foreclosure by 49 percent compared to
fixed-rate subprime lending.
"These findings suggest that predatory loans have the
potential not only to erode household wealth but also to heighten the negative impacts on
individuals, households, and communities associated with foreclosure," state study authors
"Furthermore, we estimate that the use of prepayment penalties and balloon payment requirements in
1999 refinance originations increased foreclosure-related losses by about $465 and $127 million
nationally, respectively."
The study notes that the Home Ownership Equity Protection Act
(HOEPA), which covers subprime lending, currently allows prepayment penalties for up to five years
and large balloon payments after the fifth year of a loan. The study authors recommend that HOEPA
ban these practices, as many states do. Moreover, the study points out that the Office of the
Comptroller of the Currency (OCC) has
recently exempted national banks and their operating subsidiaries from state and local predatory
lending laws.
"By effectively exempting certain lenders from state laws banning extended
prepayment penalties and balloon loan terms, OCC has become an unwitting player in a growing
foreclosure crisis in the subprime market," state the study authors. "Given the current mood among
many in Congress to adopt a national predatory lending law that would preempt state and local laws
now in effect, our findings are especially relevant."
"Failure to ban the kinds of
detrimental lending practices with which this paper deals should not be an option," the authors
conclude.
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