Editor’s note: This is the first of a three-part series.
Some lenders today are rejecting 50 percent or more of their mortgage loan applicants after the applicants have paid for an appraisal, and in some cases after they have paid a nonrefundable upfront fee to the lender. While the rejection rate varies widely from lender to lender, the overall rate is far higher than it was before the financial crisis, when rejections late in the approval process were a rare occurrence.
There are some indications that late-stage rejection rates may be highest among the largest lenders. These lenders also own, in whole or in part, the appraisal management companies (AMCs) that retain appraisers. The lender ordering an appraisal from a company in which it has a financial interest in effect receives a piece of the appraisal fee paid by a borrower the lender subsequently rejects.
There are no statistics on late-stage rejections. The statements above are based on confidential reports from professional insiders, and my mail from rejected borrowers.
The loan rejection process
Loan rejection typically occurs at one of two points. The first point is very early in the process when the loan officer or broker pulls the borrower’s credit, and does a quick study of the application. Rejection at this point is usually based on poor credit, but the application could also reveal some other glaring deficiency, such as an inability of the applicant to document income.
Such fast rejections are relatively benign, because the borrower typically has not paid any fees to the lender, has not paid for an appraisal, and has not invested much time.
Rejection that occurs later might reflect the inability of the lender to verify income or other data relevant to approval. Most often, however, late-stage rejection is based on inadequate property value as indicated by an appraisal.
Late-stage rejection is extremely costly to applicants because they are out-of-pocket $300-$700 for the appraisal and nonrefundable loan fees, and they have invested weeks of time — sometimes they are left dangling for many weeks.
While it is quite possible that a rejected borrower might be accepted by another lender, the borrower would face a new set of charges with little basis for believing that the result would be different.
Before the financial crisis, it was very unusual for the appraisal on a sale transaction to come in below the agreed-upon price, and when it happened — because the buyer had made a serious mistake in judgment — the practice was not to charge for the appraisal.
Today, appraisals come in below agreed-upon sale prices with some frequency, and the borrowers pay for them — adding insult to injury.
Why late-stage rejections have risen
The rise in late-stage rejections has been due in some degree to the more restrictive underwriting climate that emerged after the financial crisis. This includes not only more restrictive lending terms but also tougher enforcement of the rules including more extensive checks of closed loans for compliance.
Loans that fail compliance checks may have to be repurchased by the originators, which is very costly. Underwriters entrusted with responsibility for assuring that loans are not returned from buyers on grounds that they did not meet the requirements err on the side of rejection.
But the more restrictive underwriting climate is only one part of the story. A major factor underlying the increase in late-stage rejections is a decline in the quality of appraisals, which also has emerged since the financial crisis. The bias of underwriters favoring rejection increases as the quality of appraisals declines.
The aim of an appraisal is to determine the "true value" of a house, which is the price a well-informed buyer would be justified in paying for it. The quality of appraisals declines when the divergences from true value become larger, and when they become increasingly biased in one direction or another.
There are no statistics on appraisal quality, but here are some numbers I made up in order to illustrate what has happened. Before the crisis, the average divergence between appraisals and true values was 4 percent, and 70 percent of the divergences were on the high side. Today, the average divergence is 10 percent, and 90 percent of them are on the low side.
A decline in appraisal quality increases late-stage loan rejections. Lower-quality appraisals mean a larger number of cases where appraised value turns out to be so much lower than the value that had been assumed up to that point that it torpedoes the deal.
Next week: why appraisal quality has declined.