Millions of Americans increasingly turn to home-equity lenders to meet their financial needs. Which raises a question: are subprime lenders the consumers' friend or foe?
"Access to credit," Federal Reserve Board Chairman Alan Greenspan asserted earlier this year, "is essential to help families purchase homes, deal with emergencies and obtain goods and services that have become staples of our daily lives." The home-equity lending industry exists solely to provide credit to people who would generally find it difficult to receive commercial bank loans.The industry, however, is not without its critics. A recent congressional hearing (and subsequent news coverage) investigated alleged predatory practices among home-equity lenders. Straining for emotional punch, the hearing even included testimony from the hospital bed of one woman who said she'd been coerced into a loan she couldn't repay.
The hearing made for good headlines but bad analysis. While every industry has its share of shady practitioners, the home-equity lending industry performs a function vital to the continued well-being of the economy - it bears the risk of providing purchasing power to individuals with imperfect credit histories.
According to Bud Ward, a banking analyst at Ernst & Young, "This (business) has created credit for people who never had it before - and that creates buying power and jobs."
Over the past 20 years, the industry has become an even more significant source of consumer credit. And it is growing larger. The Wall Street Journal reported recently that outstanding home and auto loans to subprime borrowers surpassed $300 billion last year - a 33 percent increase over 1996.
While banks compete aggressively for consumer business, they prefer (all else being equal) to service low-risk or "prime" borrowers. Would-be borrowers with pristine credit histories and adequate income can choose from a variety of commercial banks.
When subprime borrowers need credit - to buy a home or a car, repair the roof, pay medical bills or find cash for a short-term crisis - they often can't go to the bank.
Thanks to America's entrepreneurial spirit, they now have a place to turn with the development of a strong home-equity lending industry.
Geography can also create barriers between banks and potential customers. As noted in a recent study funded by the American Association of Retired People (AARP), many banks have closed branches in some inner city neighborhoods. The AARP study cited the example of a lower-income neighborhood in West Oakland, Calif., which in 1993 had 48,000 residents but not a single bank. By comparison, Oakland's middle- and upper-income neighborhoods average a bank branch for every 2,345 residents.
The comment may have been lost in emotionalism, but an FTC official put it well at a recent Senate hearing when he noted that subprime lenders "serve communities that have been underserved by other lenders."
By definition, subprime borrowers are somewhat higher-risk customers. But as a group they have an enviable record of keeping their loans current. Drawn from every walk of American life, the vast majority of subprime borrowers are as reliable at repaying their loans as the prime borrowers preferred by banks.
And subprime borrowers do a better job of repaying loans than their counterparts who obtain government-guaranteed loans. According to a study by the Hudson Institute, 94 percent of home-equity loans of subprime borrowers are up to date, compared with 97 percent for prime borrowers and 92 percent for those in government-backed programs.
Subprime lenders fill a vitally important niche. Yes, they charge somewhat higher interest rates than banks - but fierce competition within the industry has led to lower rates. Moreover, some premium over bank rates is justified by the increased risk of the sub-prime portfolio.
In return, these lenders provide a vital public service by furnishing credit to hard-working Americans who need it and deserve it. Some of the borrowers lack a credit history; others have had tough times that led to credit problems; some have limited incomes. They don't fit the profile for the ideal borrower, but once they get the loan, almost all of these borrowers make their payments and repay their loans. For them, the subprime lender industry is a genuine friend.