Providing small loans at affordable prices has always been a challenge. The core 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 isolated communities where houses are very 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?”
The town is Winters, Texas, population about 3,000, most of whom are retirees. There are no jobs there or anywhere very close. Houses in Winters 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, for example; if one is needed the cost will be double the cost in a larger center because of the time it takes for the appraiser to get to Winters and back.
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 very 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 their loans down substantially and would like to take advantage of lower interest rates by refinancing.
“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 refi?”
Of course, it is too late. No lender wants to refinance a $42,000 loan unless it is a substantial cash-out where the new loan is much larger than the balance of the old one.
On cash-out deals where the balance and new loan amount is 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 was closing costs including the broker’s fee.
On this loan, the lender spread his costs over a $122,000 loan but the borrower’s cost of $12,000 was incurred to obtain cash of only $4,500. Plus the borrower is now paying a rate 0.25 percent higher than before on $110,000. Assuming she holds the loan for five years, her annual interest cost on the $4,500 is 32 percent.
Cash-out refinances for small amounts are almost always more costly than a second mortgage. In the case above, a second mortgage at any rate below 32 percent would have saved her 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 development of the Internet has widened borrower choice in the unsecured market enormously — at least among those who use computers. (For the others, small-loan offices are still found in many shopping centers.) Residents of Winters, Texas, 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.com, is particularly interesting. I have spent hours on their Web site and have been enormously impressed.
Prosper brings potential borrowers and lenders together 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 $100 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, even in Winters.
Prosper charges a reasonable origination and servicing fee for doing all the spade work: compiling borrower information, collecting the payments, keeping the books, and pursuing delinquent borrowers. I expect to have a fuller report on them in the near future.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
