Banks are bailing on small mortgages, driving buyers to risky alternatives

American banks are losing interest, consumer advocates say, in writing mortgages for inexpensive homes.

Their exodus from the small-mortgage market leaves a patchwork of risky, poorly regulated home-loan alternatives that can propel the most vulnerable buyers into debt or homelessness.

Twenty years ago, the median home cost less than $200,000, and banks routinely approved mortgages for half that amount. Today, the median home costs $437,000, and buyers struggle to find banks that will write mortgages for less than $150,000.

Instead, many buyers turn to alternative financing, a universe of personal property loans, lease-purchase agreements, land contracts and seller-financed mortgages. Typically, those transactions are both riskier and costlier than a mortgage, and they fall outside the regulatory cocoon that protects homebuyers from fraud and trickery.

In the worst cases, borrowers can lose their home and their solvency.

“People think that they are on the path to owning their own home, when in fact they are on a path to financial disaster, forfeiting all of the money that they have paid in, as well as the place that they thought was their home,” Sen. Tina Smith (D-Minn.) said. “Too often, these contracts are designed to fail.”

Smith spoke Tuesday at a Senate hearing with the dramatic title, Exploiting the American Dream: How Abusive Land Contracts Prey on Vulnerable Homebuyers.

Sen. Jon Tester (D-Mont.) termed the industry’s bad actors “a bunch of folks who should have a special place in Hell.”

Buyers stray outside the protective red tape of the mortgage industry for many reasons. They may have low credit scores, or lack the funds for a down payment, or wish to avoid the deep document dive that attends a mortgage application. The purchaser may lack financial literacy. The lender may be a family friend.

“My clients tend to have trusted the seller, the people who approached them with a situation that maybe sounded too good to be true,” Elizabeth Goodell, supervising attorney at Mid-Minnesota Legal Aid, said at the Senate hearing.

But consumer advocates and researchers also point the finger at banks. Mortgage lenders are growing increasingly reluctant to approve loans in the $100,000 range, because those transactions no longer turn much profit.

“It’s gotten hard for lenders to originate mortgages under about $150,000 profitably, because the size of a mortgage is a major factor in how much revenue the lender earns,” said Alex Horowitz, a project director at The Pew Charitable Trusts who studies housing.

The fixed costs of a mortgage have risen dramatically in recent years, from about $3,700 in 2009 to $10,600 in 2022, Horowitz said.

Each mortgage costs more, in part, because banks are spending more money on overhead, propping up an industry that swelled in the mortgage-refinance boom of recent years. Now, new loans are relatively scarce, and lenders favor large sums. Regulatory costs have risen apace.

A Pew analysis found that 38 percent of mortgage lenders did not issue a single small mortgage, for a home priced under $150,000, between 2018 and 2021.

The mortgage, the standard tool for homebuying, factored in only 26 percent of home sales under $150,000 in those years.

The small-mortgage exodus matters less in New York or Los Angeles, cities filled with million-dollar homes. It matters more in Akron, Ohio, and Cedar Rapids, Iowa, and Erie, Pa., where the median home is priced below $200,000.

When home buyers can’t get a mortgage, they find other ways to borrow. Pew estimates 7 million Americans used alternate financing to purchase the homes they live in now. A disproportionate share are Hispanic or Black buyers or earn less than $50,000.

The most prevalent mortgage alternative, Pew found, is the personal property loan. Commonly used to purchase manufactured (i.e., mobile) homes, personal property loans cover only the home, not the land beneath. They treat the house much like a car or refrigerator.

Personal property loans often come with sky-high interest rates. In many states, lenders can repossess the dwelling with little provocation. And most mobile homes sit on rented land, a predicament landowners can exploit.

At Tuesday’s hearing, Tester, the Montana senator, narrated an increasingly frequent scenario: “bad actors buying up manufactured housing communities and then, once they buy them, they jack up the lot rent, because they can.”

When the landowner raises rents in a mobile-home community, “that consumer is out of luck,” said Sarah Bolling Mancini, co-director of advocacy at the National Consumer Law Center. “Because most of these homes cannot be moved: They will fall apart.”

Other buyers resort to land contracts. In this arrangement, the seller extends credit to the buyer. It works sort of like a mortgage, but with a key difference: The seller often keeps the deed to the property and remains its legal owner until the buyer makes the final payment.

Like personal property loans, land contracts generally lack the standard protections of a mortgage.

“If the seller has something go wrong in their life, and there’s a lien put on the home, the buyer could lose the home even if they’re making all the payments,” Horowitz said.

Another alternative-financing option is the lease-purchase, or rent-to-own, agreement. The landlord becomes a seller, the tenant a buyer. The tenant generally pays a large upfront fee in exchange for an option to buy the home in a set span. A portion of the monthly rent, often set well above market rates, might go toward the purchase price.

Here, too, the buyer has few protections. A seller may try to back out, and the terms of the lease-purchase agreement may allow them to keep the money.

In a seller-financed mortgage, the seller acts as the lender. The deed transfers to the buyer, as in a mortgage. But without the due diligence of a mortgage, the buyer could end up with a home that is uninhabitable, or one with competing claims on its title.

Across the board, Horowitz said, “consumers usually pay more, often much more, to use alternative financing than the same consumer would pay in a mortgage.”

Consumer advocates are concerned about another rising home-loan peril, this one often targeting low-income homeowners.

Throughout the refi boom of 2020 and 2021, the mortgage industry sustained itself largely by refinancing mortgages at attractive rates. Over the past year, that market has dried up, as interest rates have risen to decade-long highs. (Nearly 7 percent, for a fixed 30-year mortgage, as of this month.)

To scare up business, lenders are lobbying homeowners to apply for a “cash-out” refi, offering cash to the owner as an incentive to refinance the mortgage.

In the low-interest days, millions of homeowners took on new mortgages that deposited dollars into their bank accounts, often with a lower rate to boot.

Today, a cash-out refinance makes little sense: Yes, you’ll come away with money in the bank, but you may also wind up paying twice as much interest on the new mortgage.

“You are trading your existing mortgage, which, for most people, is in the 3-percent range, for a mortgage in the 6- to 7-percent range,” said David Silberman, a senior fellow at the Center for Responsible Lending.

Desperate homeowners fall for the pitch, Silberman said, even if it means higher mortgage payments for the next 30 years.

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