Even the Smallest of Loans Has a Price

8 08 2007

Providing small loans at affordable prices has always been a challenge. The problem is that the cost of originating and servicing a loan is much the same for a small loan as for a large one, but the interest return, based on the loan amount, is smaller on the smaller loan. The obvious remedy, a higher interest rate on the smaller loan, makes it costly and perhaps unaffordable.

The price sheets of lenders in the United States generally show higher first-mortgage rates on smaller loans, with minimum sizes ranging from $50,000 to $75,000.

Who needs a mortgage of less than $50,000? For one, people who live in communities where houses are inexpensive.

“In my town, we need mortgage loans from $5,000 to $30,000, and they just aren’t available. Is there anything that can be done?” a reader wrote.

The town is Winters, Tex., population about 3,000, most of them retirees. There are few jobs anywhere close, and houses sell for less than $60,000.

Mortgage loans are not available in Winters. In part, this is because the town is so isolated and the demand so small that it can’t support a lending facility. There are no appraisers in Winters, so the price of an appraisal is double what it would be in a larger town because of the travel time involved.

But the major problem is that the loans are too small to justify the cost of originating them. A mortgage origination cost of $5,000, which is a modest number, is 10 percent of a $50,000 loan, though only 1.7 percent of a $300,000 loan.

Another category of borrowers vulnerable to the small-loan problem are those who have paid down their loans substantially and would like to take advantage of lower interest rates by refinancing.

A homeowner asks, “I have a 10 percent loan from way back, but should have refinanced years ago; the balance is only $42,000 now — is it too late to refinance?”

Yes, it is too late. No lender wants to refinance a $42,000 loan unless it is a substantial cash-out, whereby the new loan is much larger than the balance of the old one.

On cash-out deals in which the balance and new loan amount are large but the amount of cash taken out is small, the small-loan problem hits the borrower but not the lender. A reader recently described a deal in which she refinanced a $110,000 loan at 6.75 percent into a $122,000 loan at 7 percent. Of the $12,000 increase in the balance, $4,500 was the cash she took out and $7,500 consisted of closing costs, including the broker’s fee.

On this loan, the lender spread his costs over a $122,000 loan but the borrower incurred costs of $12,000 to obtain $4,500 in cash. Plus the borrower is now paying a rate 0.25 percentage points higher than before.

Cash-out refinances for small amounts are almost always more costly than a second mortgage. In the case above, a second mortgage would have saved the borrower money. Indeed, she might possibly have done better in the unsecured loan market.

The great majority of loans for amounts of less than $50,000 are second mortgages or unsecured. The Internet has widened borrower choice in the unsecured market enormously — at least for those who use computers. (For the others, small-loan offices are still found in many shopping centers.) Residents of Winters should forget about getting mortgages and shop for unsecured loans on the Internet.

A relatively recent online entrant into the unsecured loan market, called Prosper ( http://prosper.com), is particularly interesting. I have spent hours on the Web site and have been impressed.

Prosper brings together potential borrowers and lenders in a virtual market that appears to provide an attractive return to lenders and a reasonable cost to borrowers. Lenders, of which I will shortly be one, are given extensive information about borrowers, including credit information and referrals. They can lend as little as $50 on any one deal, which allows them to diversify their risk without committing larger sums. Because it is a virtual market, borrowers can live anywhere, including Winters.

Prosper charges a reasonable origination and servicing fee for doing all the spadework: compiling borrower information, collecting payments, keeping the books and pursuing delinquent borrowers. I expect to have a fuller report on them soon.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

Copyright 2007, Jack Guttentag

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