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Fed’s Duke Addresses Concerns for Borrowers with Low Credit Scores

As the housing market experiences a burgeoning recovery with rising prices, an uptick in sales, and an increase in housing starts, ""Federal Reserve"":http://www.federalreserve.gov/ Governor Elizabeth A. Duke points out purchase-originations remain ""subdued,"" especially among individuals with less than stellar credit scores.

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While originations are down across the board, ""[t]he drop in originations has been most pronounced among borrowers with lower credit scores,"" Duke said at the Housing Policy Executive Council Thursday in Washington D.C.

From 2007 to 2012, purchase originations among borrowers with credit scores higher than 780 declined by 30 percent. In contrast, purchase originations for borrowers with credit scores between 620 and 680 declined by 90 percent, and originations among borrowers with credit scores below 620 were ""virtually nonexistent,"" according to Duke.

Duke reasoned some lower-credit score households may not be seeking mortgages as they may have ""suffered disproportionately from the sharp rise in unemployment during the recession.""

However, she also points to tight credit conditions as a major contributor to the drastic decline in originations for borrowers with lower credit scores.

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A few conditions leading to tighter lending standards--capacity constraints and apprehension toward the future of the economy and the housing market--""are likely to unwind through normal cyclical forces,"" according to Duke.

Other sources of tight credit may persist or have less predictable outcomes, according to Duke. Many of these sources stem from regulatory changes in the industry.

""New mortgage regulations will provide important protections to borrowers but may also lead to a permanent increase in the cost of originating loans to borrowers with lower credit scores,"" Duke said.

For example, servicing standards are now more stringent, especially for defaulting loans, but servicer compensation remains the same. Servicing a delinquent loan is more costly, more time-consuming, and earns a servicer no additional compensation. As such, banks may continue to shy away from loans that demonstrate any likelihood of default, Duke said.

Additionally, the qualified mortgage (QM) rules from the Consumer Financial Protection Bureau could deter lenders from making loans to borrowers with lower credit scores, according to Duke.

A QM requires a borrower's total debts to equal less than 43 percent of his or her income, which will exclude some ""less-advantaged borrowers,"" Duke said.

The QM also restricts the amount and method through which servicers may charge risky borrowers. If a borrower has a greater likelihood of default, a lender may wish charge a higher interest rate to compensate for the risk. The QM does not allow servicers to charge more than 150 basis points more to any one borrower than what they charge their highest-quality borrowers.

In order to fall under the QM, a mortgage also cannot have points or fees exceeding 3 percent of the loan amount.

""The extent to which these rules regarding rates, points, and fees will damp lender willingness to originate mortgages to borrowers with lower credit scores is still unclear,"" Duke said.

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