In a report to federal banking regulators, the Federal Trade Commission suggested current subprime loan disclosures only confuse prospective borrowers and often don't convey the real terms of the loan. The agency has developed its own one page disclosure that it said greatly increased the borrower's understanding of loan terms.
The FTC responded Tuesday to the federal banking agencies' request for comment on their proposed illustrations of consumer information disclosures for subprime loans. Specifically, the FTC recommended that the agencies test whether the proposed disclosures will achieve their purpose of helping subprime borrowers make better informed loan choices and then develop a single disclosure document that summarizes key loan information.
The proposed illustrations are currently two documents, one that lists important facts about adjustable-rate mortgages and another that charts how much a borrower will pay throughout the first five years on a 2/28 ARM versus a fixed-rate loan. The disclosures are consistent with the Statement on Subprime Mortgage Lending guidance issued by the agencies, which consist of the Federal Reserve System's board of governors, Federal Deposit Insurance Corp., Office of Thrift Supervision and National Credit Union Administration.
"The information in the illustrations is largely general and often hypothetical," the FTC said, further emphasizing that the first illustration provides few loan-specific details and that the second is purely a hypothetical example.
The Subprime Statement itself could be contributing to possible ineffectiveness because it is unclear on the precise timing of when within the shopping process consumers should be informed of material terms, benefits, costs, and risks of loan products. It states this should be done in a "timely manner to assist consumers in the product selection process, not just upon submission of an application or at consummation of the loan," the FTC said. "This early timing may account for some of the lack of specificity in the disclosures."
The FTC suggested that the agencies' testing of whether the proposed disclosures will benefit consumers should include procedures to evaluate how well the illustrations address the serious problems highlighted in the Subprime Statement, which are payment shock, prepayment penalties, balloon payments, the cost of reduced documentation loans, and responsibility for taxes and insurance. The research procedures should also examine the role the illustrations will play within the current, overall mortgage disclosure environment.
In addition to testing, the FTC said the agencies should consider engaging in a more comprehensive effort to improve federal mortgage disclosures because those proposed may not substantially improve borrowers' overall understanding of their actual loan choices.
"The disclosures include only a partial list of potentially costly loan attributes, and little loan-specific detail about these attributes," the FTC said in the report. "In addition, the proposed disclosures would be added to the often-confusing disclosures that consumers already receive."
The recommendation for the agencies to consumer test the proposed disclosures before implementation is based on two studies the FTC has conducted that demonstrated the potential benefits of doing so.
A 2004 study on mortgage broker compensation illustrated that more information is not always better than less, as compensation disclosures led to incorrect understandings of loan costs and biased loan choices.
A study earlier this year revealed that consumers frequently misinterpret the Truth-in-Lending Act statement and the Good Faith Estimate. Among other things, it was found current mortgage disclosures frequently fail to convey key information to consumers, that disclosures, even on simple, fixed-rate, fully amortizing loans, often confuse consumers, and that the findings apply to both prime and subprime borrowers.
This mortgage disclosure study also demonstrated the potential benefits of having a single summary disclosure document that combined information about all key mortgage attributes and costs. Improvements provided by the prototype included a 66 percentage point increase in the proportion of respondents correctly identifying the total amount of up-front charges in the loan. Overall, there was a 19 percent improvement in correctly answered questions when respondents examined loans using a single prototype form over when they examined the same loans using current disclosures.
The commission's comments indicated that enhancements to the prototype disclosure it developed and tested in the mortgage disclosure study could address the highlighted problems in the Subprime Statement. In its current form, the prototype already provides a demonstrably clearer and more comprehensive prepayment penalty disclosure and explicitly indicates whether escrow payments for taxes and insurance are included in the monthly payment estimates. Adding an adjustable interest rate disclosure with key aspects of such loans could make it more responsive to the concern of payment shock, and testing revealed room for improving the balloon payment disclosure.
In any case, research has shown "consumers likely would benefit from one clear disclosure document that alerts them to the major costs and features of a mortgage; will significantly reduce the cost of obtaining information about the true value of different mortgage options; is noticeable, easy to read, and easy to understand; summarizes key loan features upfront to facilitate informed comparison shopping; and makes clear what a consumer is getting into before signing on the dotted line," the FTC said. "Such a document could be developed using principles from consumer finance, communications design, and consumer research."