July 10, 2012
Written By Chloe Lutts Jensen
“The U.S. recovery is hobbled by an economic divide that separates Americans not by income or wealth but by their access to credit.
“The housing bust left behind millions of people with credit records damaged by plunging home prices, lost jobs, past overspending or bad luck. Many are now walled off from the low interest rates engineered by the Federal Reserve to spur the economy and remedy the aftereffects of the borrowing boom.”
Those are the first lines of a June Wall Street Journal article that revealed how the Fed’s low interest rate policies are disproportionately benefiting consumers with high credit scores, to some extent keeping those with lower scores from participating in or helping along the economic recovery.
Several charts that accompanied the article tell the story by the numbers:
As you can see in the top left chart, households with credit scores of 700 or higher received almost 90% of the new mortgages made last year, a sharp increase from about 50% in 2007.
Obviously, the financial crisis made banks understandably more wary about making risky loans — as it should have. No one wants to go through that again. But it’s worth asking, as the WSJ does, if the pendulum has swung too far the other way.
Homeowners with credit scores under 700 (scores range from 300 to 850, with about 60% of people falling between 650 and 799) now receive only about 10% of mortgages. As you can see in the WSJ’s pie chart, banks are significantly less likely to give them loans than in the past. And when they can get a mortgage, their rates are higher.
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While it may be tempting, in the wake of the sub-prime mortgage crisis, to applaud banks for (finally) being risk-averse, there are larger consequences to think of, the WSJ writes:
“Shrunken access among credit have-nots is triggering more than personal plight. It has weakened the influence of the Fed — one of the best hopes for spurring stronger economic growth. Fed officials have been frustrated in the past year that low interest rate policies haven’t reached enough Americans to spur stronger growth, the way economics textbooks say low rates should.
“By reducing interest rates — the cost of credit — the Fed encourages household spending, business investment and hiring, in addition to reducing the burden of past debts. But the economy hasn’t been working according to script. …
“The problem for the Fed is that the pipes in the financial system through which its easy money travels are clogged.
“An April Fed survey found that 83% of banks were less likely to approve a new mortgage for a household with a low credit score of 620 and a 10% home down payment than they were in 2006, even a loan guaranteed by Fannie or Freddie.
“ ‘This is a big limitation on the potential effects of monetary policy,’ Charles Evans, president of the Federal Reserve Bank of Chicago, said in an interview last month. ‘Normally we’d have a very large refinance boom. People would be able to trade in their high-interest-rate mortgage for lower ones and their mortgage payment would go down. That would put more spending power in the hands of anybody in a position to do that. That would increase aggregate demand. That is the way it is supposed to work.’ ”
In other words, low interest rates should, in theory, reduce consumers’ costs in some areas so that they can spend more in others, spurring economic growth. But the Fed’s low rates are actually only cutting costs for a small sector of consumers, those with good credit scores. And according the WSJ, those consumers are less likely to turn around and spend that money on goods and services: “Wealthier households are more likely to save or invest a windfall because they can already consume as much as they want, according to standard economic theory and research.”
There’s one more aspect of the problem that the WSJ didn’t mention, but that immediately sprang to my mind: younger people tend to have lower credit scores.
Not only is the length of your credit history a direct factor in your credit score, but younger people are also more likely to have “recently” made a mistake (like forgetting a loan payment) that is still affecting their credit years later. Most young people are not very knowledgeable about credit scores when they get their first credit card or car loan, and unfortunately they often only end up learning by making mistakes. Those mistakes can remain a factor in their credit for years.
Why does that matter?
Young people are more likely to be first-time homebuyers, who aren’t going to replace the house they take off the market with one they have to sell.
In general, younger people are more consumption-oriented: someone in his early thirties who is able to save $200 a month by refinancing his mortgage is more likely to spend that $200 on goods and services than a 50-something homeowner in the same situation who is saving for retirement.
So banks’ reticence to lend to the under-700 set is most likely overwhelmingly benefiting older, wealthier borrowers. And those borrowers aren’t using the Fed’s easy money to help the economy — at least, not as much as younger, poorer borrowers would.
What should be done? I don’t know, but I’d love to hear your ideas. Do you think this is, in fact, a problem, or are you just glad banks are finally being responsible? And if you think it is a problem, how would you propose the Fed more effectively spur the economic recovery?
I look forward to reading your responses.
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