After years of turning down all but the best borrowers, banks and other lenders are now extending credit to a surprising group of customers: former homeowners who defaulted on their mortgages.
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In another sign that borrowing is easing up, some banks are extending credit beyond the best borrowers to include those with significant blemishes on their credit reports, says James Chessen, chief economist at the American Bankers Association. At the moment, borrowers who have defaulted on their mortgages -- but are current on all other loans -- are among the attractive candidates for new loans. Between February 2009 and August 2010, 64,500 borrowers who had defaulted on a mortgage received a consumer loan, according to a study released last week by credit bureau TransUnion. The majority secured credit cards, but almost 40% got car loans or a personal loan or line of credit, according to TransUnion's study.
And while more recent data isn't available, experts say the number of loans granted to mortgage defaulters has likely continued to grow. "It's certainly loosened up now," says John Ulzheimer, president of consumer education at SmartCredit.com, a credit-monitoring site. "I would say [lending] is more prevalent than the TransUnion study suggests."
The banks approving these loans consider these borrowers a special group, says Steven Chaouki, a vice president for financial services at TransUnion: Because they are current on all other loans, banks see them as a lower risk relative to borrowers who have missed payments on multiple loans. The housing bubble and bust put otherwise responsible borrowers into bad situations, says Marcus Stanley, policy director at Americans for Financial Reform, a public interest advocacy group. "A lot of responsible people through no fault of their own found themselves in mortgages that weren't practical for them."
For banks that are wading back into lending to borrowers with less-than-stellar credit, this group represents a small step into the risk pool. If a bank feels confident that the borrower is back on his feet financially, they are willing to take the risk to lend to them, says Chessen. The early data seems to bear it out. According to the TransUnion data, so-called "mortgage only" defaulters missed car-loan payments half as often as borrowers who have missed payments on several past loans. For credit cards, the difference was wider: 11% of the mortgage-only defaulters missed payments, compared to 27% for delinquent borrowers.
Few banks will openly acknowledge lending to or courting these borrowers. Most say they view a mortgage default as a significant risk. A Wells Fargo spokeswoman says the bank would consider such a loan, but it would have to believe the borrower is willing and able to repay the loan and it would take into account special circumstances such as whether the borrower has a "deep relationship" with the bank and if the default was an isolated incident. Bank of America, HSBC and SunTrust say that they weigh several factors before making a loan and don't focus on one risk factor in particular.
For some consumers, this is a welcome relief. In general, a foreclosure hurts a credit score for seven years, says Ulzheimer of SmartCredit.com. A borrower with a 720 FICO credit score could drop to around 570 after foreclosure. Still, early on in the downturn, a borrower with a 570 score would be hard-pressed to get approved for a credit card -- at least one that didn't require a cash deposit and charged rates that were as high as 79% -- let alone a car or personal loan, says Ulzheimer.
This lending, however, has its downsides for consumers, starting with higher interest rates. While the average credit card interest rate is 15%, these borrowers can expect to get rates from 20% to 25%, Ulzheimer says. The average rate on a new car loan is around 4.7% for borrowers with top credit, but for these borrowers rates could be as high as 19%. A bigger -- if less likely -- potential risk is if the lender of the defaulted mortgage is building a case for a lawsuit: In many states, banks can sue a borrower who defaulted on their mortgage for losses, also known as recourse. If the borrower is paying other loans, it may encourage the lender to seek recourse, says Robert Lattas, a real estate attorney in Chicago. The result could be sending the case to collections or, less often, getting a judgment from the courts to collect.
Some experts also wonder if such relaxed lending practices could lead to yet more mortgage defaults. With comparatively few repercussions for foreclosures, borrowers especially those who owe more on their home than it's worth could be emboldened to walk away, they say. There's also the question of whether consumers might be better off recovering from a foreclosure by sticking to cash and not drowning deeper in new debt.