Academic journal article The Journal of Consumer Affairs

Protecting Mortgage Borrowers through Risk Awareness: Evidence from Variations in State Laws

Academic journal article The Journal of Consumer Affairs

Protecting Mortgage Borrowers through Risk Awareness: Evidence from Variations in State Laws

Article excerpt

In the wake of historic levels of mortgage defaults, regulators have debated how to regulate certain high-risk loans because of the risks of foreclosure involved. This study examines state laws that required loan applicants to receive information about the risks of foreclosure before they could sign certain mortgage contracts. Skeptics suggest that disclosures are largely ignored by consumers, yet controlling for other factors this study shows that loan applicants in states with enhanced warnings about foreclosures were more likely to reject high-cost refinance mortgage loan offers from a lender. Enhanced disclosures with features such as risk warnings, signatures, and referrals to counseling are being implemented as part of Dodd-Frank consumer finance reforms. This study suggests these strategies may be useful to balance consumer protection and access to high-risk credit.

INTRODUCTION

In the early 2000s, lenders developed more refined techniques for assessing and pricing consumer credit risk, which in turn expanded the ability of borrowers with poor credit to gain access to the mortgage market (Gramlich 2007). This expansion of access to credit was largely unprecedented, opening homeownership to some classes of borrowers for the first time (Schwartz 2011). However, even during the boom, consumer advocates worried that lenders were taking advantage of consumers and exposing borrowers--and ultimately society as a whole--to too much risk (Barr 2012; Engel and McCoy 2011). The surge in mortgage foreclosures in 2008 and subsequent years have heightened the debate over whether high-risk consumers should be offered mortgage contracts at all. Banning certain kinds of loans or borrowers is not always practical. Some consumers who could successfully comply with high-risk loan terms may be left worse off by being excluded from the market.

One partial solution is to implement policies that help potential borrowers to more realistically assess the risks of default before signing a loan contract with a willing lender. Providing mortgage loan applicants with information about the risks of losing their home in foreclosure may help those consumers who would otherwise undervalue the risks involved in a mortgage contract to re-evaluate their options and decide not to borrow. Consumer protection advocates who worry that myopic borrowers do not understand or appreciate the risk of default may find that carefully designed risk warnings can provide at least a partial remedy for uninformed borrowers agreeing to risky loan terms. More typically, however, mortgage disclosures are viewed as offering little or no real information, instead drowning loan applicants in a sea of legalese (for a discussion, see Durkin 2002; Kroszner 2007). The impact of mortgage information disclosures is an issue that needs to be understood as regulators implement credit market reforms and consumer protection rules in the aftermath of the mortgage crisis.

The debate over whether disclosure policies are a mechanism to facilitate informed consumer choices or a wasteful bureaucratic requirement is one that has not been carefully addressed in the empirical literature. This article examines whether loan applicants who were required to receive enhanced risk disclosures during the housing boom were more likely to reject a loan offer from a lender compared with similar loan applicants not subject to these disclosures. The study uses individual-level refinance mortgage loan applications from data provided under the Home Mortgage Disclosure Act (HMDA), and identifies effects of enhanced disclosures using the variation in state disclosure laws. The findings suggest that risk disclosures, particularly those requiring a signature, are associated with loan applicants rejecting approved loan offers at higher rates compared with similar borrowers not subject to augmented disclosure policies.

BACKGROUND

All loan applicants receive a Truth in Lending Act of 1968 (TILA) disclosure as part of the credit application process (Durkin 2002; Durkin and Elliehausen 1999). …

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