Bad Credit and Intergroup Differences in Loan Denial Rates

Research has found wide disparities in loan denial rates among different racial/ethnic groups. Two competing explanations for these gaps arise. One argument is that these disparities result from underlying racial disparities in credit worthiness. A competing view is that the disparities arise from a pattern of racial discrimination among mortgage lenders. This paper adopts a stratification economics approach to evaluate these competing claims. Using Freddie Mac’s Consumer Credit Survey dataset, we test the hypothesis that measures of discrimination disappear when one accounts for racial differences in credit scores. A novel contribution of the paper, built upon the premise that inter-group inequalities sustain themselves through self-fulfilling mechanisms, is to test the hypothesis that loan denials explain misperceptions of credit worthiness. We demonstrate that one cause of the appearance of poor credit risk among black applicants is that blacks with good credit risk underestimate their credit worthiness and apply for loans in lower numbers. Our findings suggest that even nondiscriminatory lending behavior has the unintended effect of screening out low-risk blacks and thereby yields higher denial rates among blacks. This in turn confirms prior beliefs about the poor credit of average black applicants. Much, but not all, of the racial disparity in loan outcomes can be explained by racial differences in credit scores and the resulting racial disparity in loan outcomes explains much of the racial difference in false perceptions about bad credit. Thus, a possible self-fulfilling mechanism remains within the credit market that perpetuates views about black bad credit. Copyright Springer Science+Business Media New York 2015