Academic journal article Economic Commentary (Cleveland)

Measuring Pricing Bias in Mortgages

Academic journal article Economic Commentary (Cleveland)

Measuring Pricing Bias in Mortgages

Article excerpt

Detecting and measuring discrimination in the pricing of mortgage loans present unique challenges for bank regulators. This Economic Commentary outlines how loans are priced in the mortgage market and the difficulties involved in comparing the prices charged to different borrowers.

Whether lenders discriminate against minority applicants is a long-standing question that has vexed regulators, bankers, and policymakers alike. The debate over this issue was fueled in the early 1990s by the findings of the socalled Boston Fed Study, which found that minority applicants in Boston were roughly 40 percent more likely to be rejected for mortgage loans than similarly situated whites.1 In the wake of this study, examiners at the Federal Reserve and other bank regulators began using advanced statistical techniques to help evaluate whether minority applicants face discrimination in home lending.

In recent years, the focus of fair-lending enforcement has expanded to include the pricing of mortgage credit. Thus, in addition to investigating whether lenders' underwriting decisions are affected by an applicant's race or ethnic status, regulators also try to determine whether minorities pay higher interest rates and fees for mortgages once they are approved. Although such an investigation sounds straightforward, measuring discrimination in the pricing of mortgage loans is complicated by the fact that mortgages are typically priced along two dimensions-the interest rate and up-front fees (or "points")-which may be traded off against each other. As a result, it can be difficult in practice to compare the total price charged to two different borrowers.

This Economic Commentary highlights some of the complications this structure creates when comparing the prices charged different borrowers and discusses two ways of making various loans comparable: "overages" and the "annual percentage rate." Although it is sometimes used in fair-lending investigations, the annual percentage rate has inherent flaws that make it a poor tool for detecting and measuring discrimination in the pricing of mortgage loans. In contrast, such problems do not exist with overages, making this measure a better tool for evaluating fair-lending compliance.

Mortgage Loan Pricing

Mortgage loans are priced along two dimensions. The first is the loan's nominal interest rate. The second is the upfront fees, or points, that borrowers typically pay at the time the loan is closed. A point, which is equal to 1 percent of the loan amount ($1,000 on a $100,000 loan), is generally categorized in one of two ways. Origination points cover the lender's costs associated with originating the loan, but do not typically cover ancillary services such as credit reports and appraisals (additional processing fees are usually charged to pay for these services). Discount points, meanwhile, are used to modify the interest rate paid by the borrower. By paying discount points at the time of closing, borrowers are able to obtain lower nominal interest rates on their loans.

Although most lenders charge a uniform number of origination points to all borrowers with a given loan product, the number of discount points and the nominal interest rate charged on any particular loan is the result of negotiations between the borrower and the loan offcer who originates the mortgage. As a baseline from which to begin these negotiations, loan officers work from a rate sheet, which details the number of discount points the lender requires for any given nominal interest rate, as well as the length of lock, or commitment period for that rate.2

It is important to know that many mortgage lenders-but by no means allpermit their loan officers to deviate from the rate sheet when negotiating the price of the loan. As a result, the ultimate "price" paid for a loan at a given lender may differ among borrowers, depending on their willingness to negotiate and the skill with which they do so. …

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