An individual’s likelihood of defaulting on a mortgage is directly related to their ability to perform basic mathematics calculations, a US bank has claimed. According to the study, the dramatic rise in subprime mortgage defaults in recent years can be attributed to borrowers' poor numerical ability and may have precipitated the recent global financial crisis.
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The GFC was partially caused by an explosion in US mortgage defaults which caused much of the industrialised world to be dragged into a lengthy recession. Until now, most research reports have focused on the risky behavior and revised policies of money lenders. However, there has been relatively little analysis of the role of borrowers and their ability to make sound financial decisions in relation to a mortgage contract.
In a bid to discover why borrowers take out mortgages they can't repay, researchers from the Federal Reserve Bank of Atlanta and the University of Lausanne in Switzerland analysed the mortgage characteristics and payment records for 339 subprime borrowers who initiated loans in the US between 2006 and 2007. The numerical ability of each borrower was assessed via a telephone survey.
The researchers found that borrowers with lower numerical ability spent more time in delinquency and experienced a greater frequency of foreclosure than individuals with higher numerical ability -- even after socio-demographic variables were taken into account. This was caused by a number of factors including a lesser ability to choose the right mortgage contract, maintain a budget or think ahead.
"Optimal mortgage choice turns out to be a very complicated problem with often surprising implications," the paper explains. "Individuals with better cognitive abilities may be better able to anticipate future contingencies and choose a mortgage with payment streams that better accommodate those contingencies."
Borrowers with higher financial literacy levels were found to be much more proficient at negotiating with mortgage lenders to obtain better contract terms, such as lower interest rates and the absence of prepayment penalties.
"Our results suggest that differences in numerical ability play an important role quantitatively in terms of predicting the incidence of mortgage default and that this effect is also present for individuals who hold fixedrate mortgages," the authors conclude.
"Thus, imposing restrictions on the set of available mortgage products that could be offered to borrowers would likely not solve the problem of elevated mortgage defaults during periods of declining house prices."