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Are demands for higher FHA mortgage loan credit scores discriminatory?

Can lenders demand a higher credit score than FHA guidelines require? Are demands for such higher scores evidence of discrimination?

“This decision is arbitrary,” says John Taylor, president & CEO of the National Community Reinvestment Coalition, “because the loans are 100% guaranteed, whether the borrower’s credit score is 580 or 780. That means the loans with lower credit scores don’t pose additional risk to the company, so there’s no legitimate business defense for this across-the-board practice.”

The NCRC says it’s filing complaints against 22 lenders with credit score standards above FHA requirements, alleging they violate the Federal Fair Housing Act on the grounds that such policies have a disparate impact on the African-American and Latino communities.

A Brief History of Discrimination

The refusal to sell, rent, finance or refinance real estate to an individual because of their race, color, religion, sex, handicap, familial status or national origin is banned under the Civil Rights Act of 1966. In addition, there are other laws designed to make the real estate marketplace equally open to everyone, including:

In the South legalized segregation arose after the Civil War which largely prevented African Americans from owning land or obtaining mortgage financing. Elsewhere, gentlemen’s agreements were in force, social arrangements which prevented African Americans, Jews, Catholics and others from buying or financing property in certain communities and neighborhoods. Deed covenants routinely reflected legal and social discrimination. It wasn’t until 1948 that the Supreme Court in Shelley v. Kraemer ruled that such deed restrictions could not be enforced.

Appraisals

Regardless of the laws on the books — and no matter what the courts said — real estate discrimination continued for generations after the passage of the Civil Rights Act of 1866.

For instance, standard industry practices literally required appraisers to downgrade homes in integrated communities and neighborhoods.

As we wrote in 2009:

For example, it wasn’t until 1977, according to The Washington Post, that basic appraisal textbooks were updated to say “it was once common practice to examine the racial, religious or ethnic composition of a neighborhood in an effort to detect any sign of nonconformity or change. Such an approach is now regarded as misdirected and the use of factors relating to the racial, religious or ethnic composition of a neighborhood in arriving at a conclusion of value is now deemed an unreliable practice.” (See: Appraisers Institute Settles Suit, Nov. 19, 1977)

In 1980, the appraisal industry finally agreed to a policy which said that “the value attributed to the property is not dependent upon the homogeneity of racial, religious or ethnic characteristics of the neighborhood…and the lack of such homogeneity in a neighborhood does not cause a diminution of value.” (See: Agreement Set In Rights Case Against Lenders, The Washington Post, Jan. 26, 1980)

Under the old rules merely by integrating, neighborhood home values would automatically go down — indeed, values were required to go down — not because of the worth of bricks and mortar but because of the people who lived in the community.

Perspective

The impact of past discriminatory practices shows up today.

African American and Hispanic households have far less wealth than white families. The Census Bureau reports that in 2004 the typical net worth of white households stood at $98,025. This compares with $8,650 for African-American households and $13,375 for households of Hispanic origin.

One reason for the absence of intergenerational wealth concerns property ownership. Example: Because Mr. Smith, an Afro-American, was denied a mortgage decades ago, his children did not inherit a house and the wealth it represented over time. They rented and could not write-off mortgage interest.

Real estate wealth was used by white families to buy better homes, start businesses and pay for college educations. African American families lost such opportunities when they could not obtain housing or financing on an equal basis; indeed, even African-American military veterans often could not obtain promised benefits according to Whitewashing race: the myth of a color-blind society by Michael K. Brown.


Lastly, discrimination is not an historic memory. Just consider that the Claims Resolution Act of 2010 — legislation designed to compensation African-American farmers and others for past discrimination by the Agriculture Department — was only signed into law this month, December 2010.

Credit Scores

Credit scores were introduced in the 1980s and have been revised and perfected since then. Credit scores reflect such measures as how many credit accounts are held by an individual, the amount of credit outstanding and the percentage of credit used.

There are credit score differences among borrower groups. According to the NCRC, in 2008 “about 28 percent of borrowers in predominantly African-American zip codes have FICO scores between 580 and 620 compared to just 18 percent of borrowers in white zip codes.”

But according to FHA Commissioner David H. Stevens lenders need to look at credit scores in context.

“We know that lower credit scores, in and of themselves, indicate a higher risk of default,” says Stevens. “But, as we have discussed with industry stakeholders for months, borrowers with the same credit scores can pose very different risks. For instance, a habitual late payer is likely to pose a different risk than someone who lost his or her job but otherwise has a history of paying their bills on time. It has been well documented that homeownership produces better outcomes for health, education, and long term wealth. Denying responsible families the opportunity to own a home based solely on their credit score is in no one’s best interest and may have a disparate impact on many.”

Household Income

Median incomes differ substantially among various groups. The Census Bureau reports for 2007, the latest figures we have available, that the median income for white households was $52,115. This compares with African-American ($33,916), Hispanic ($38,679) and Asian ($66,103) households.

Underwriting

All mortgages have certain standards which must be met before loans can be originated, standards such as a given level of debt to income or housing costs to income. Many loans also have certain credit score requirements.

Lenders can generally have whatever standards they want for loans. However, if they want to have their loans insured by the FHA then they must at least meet the standards for such coverage.

As an example, HUD requires that borrowers have a credit score of at least 500 to get an FHA loan. However, borrowers with a credit score of less than 579 must put down at least 10 percent in cash at closing. For those with a credit score of 580 and above the downpayment requirement is 3.5%.

In October 2010 HUD reported that the average score for an FHA borrower was 702. There were very few loans at 580 or below. According to the 2010 FHA Annual Report to Congress, only 1.3 percent of all FHA borrowers had a credit score below 600.

The FHA does not loan money to home buyers. Loans are instead made by individual lenders. Qualifying loans are then insured by the FHA when borrowers want to purchase a home with substantially less than 20 percent down.

Lenders often have addition requirements for FHA loans. They might, for example, require a higher credit score than the FHA minimums. Higher standards are called layering.

Layering

Is the process of layering fair? What if the FHA requires a credit score of at least 580 but a lender requires not less than 620 or 640?

A central point made by the NCRC is that once FHA underwriting standards are met lenders have no additional liability for such insured financing. In the event of foreclosure the lender will be made whole unless the loan was originated on the basis of fraud.

HUD, for its part has just announced that it will investigate NCRC allegations regarding 22 lenders to see if the use of higher credit scores for FHA loans creates a discriminatory impact.

What will happen next? Stay tuned.

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