The Value of Pre-Purchase Housing Counseling

A companion trend to the surge in homeownership over the past three decades has been the development of home-ownership counseling as a sizeable industry. In the battle to boost financial literacy by capitalizing on "teachable moments," pre-purchase home ownership counseling is viewed as an important weapon. Consequently, lenders, non-profit organizations, government agencies and others administer a variety of counseling programs through many mechanisms, including classroom, home study, and individual counseling sessions as well as the telephone. However, until very recently there was almost no empirical evidence regarding the effectiveness of these programs.

This past summer Freddie Mac released the results of an internal study of loans in one of its affordable-housing programs to determine whether a pre-purchase counseling requirement had any measurable effect on loan performance. The Affordable Gold program is available to borrowers with annual incomes at or below the median for their geographic area. On the loans it purchases in the program, Freddie Mac adopts more flexible underwriting standards, including expanded debt ratios and acceptance of a variety of alternative sources of funds for down payments and closing costs. Beginning in 1993, the company began requiring that each Affordable Gold loan have at least one qualifying borrower that received pre-purchase home ownership counseling. Lenders can determine the characteristics of the counseling, but must record the type of organization that provides the counseling (lender, non-profit, government agency, or "other") and the type of counseling delivered (classroom, home study, individual counseling, or telephone).

The Freddie Mac researchers examined the performance of nearly 40,000 mortgage loans originated under the Affordable Gold program between 1993 and the end of 1998. Performance on loans was measured as of the end of the second quarter, 2000 so that all loans studies had at least 18 months of performance history. About 1,200 loans were exempted from the counseling requirement on the basis of their perceived lower risk (at least one co-borrower had previously owned a home, or the loan-to-value ratio of the mortgage was 95 percent or less, or borrowers had cash reserves after closing equal to at least two monthly mortgage payments). These 1,200 loans form a "control group" to which the performance of the counseled loans was compared.

Performance was measured in terms of the percentage of loans that ever became 90 days delinquent. The researchers examined three questions:

• Does pre-purchase homeownership counseling demonstrably reduce the 90-day delinquency rate?

• Do the different types of pre-purchase counseling programs vary in their effectiveness?

• Are any counseling providers more or less effective in administering their programs?

The researchers found that counseling was effective in reducing serious mortgage delinquency, but the benefits varied with the type of counseling. Borrowers receiving counseling through individual programs experienced a 34 percent reduction in delinquencies, other things equal. Borrowers receiving classroom and home study counseling had rates 26 percent and 21 percent lower, respectively. Interestingly, there was no evidence that telephone counseling reduced delinquencies. Finally, the type of organization providing the counseling did not matter in achieving lower delinquency rates.

These results have some interesting implications. Counseling can be resource-intensive. One solution in recent years has been to lower the cost of providing counseling and increase the convenience and speed of delivery for borrowers by offering telephone counseling. The authors note that over one-third of the borrowers currently in Freddie Mac's Affordable Gold program receive telephone counseling. However, this method produced no significant reduction in delinquencies, in contrast to the other delivery mechanisms. Given the evident trade-off between cost and effectiveness, the study authors suggest that a more effective strategy may be to require counseling only for the highest risk borrowers, but to require that it be provided in either an individual, classroom or home study format as opposed to over the telephone.