One popular narrative of the subprime/foreclosure crisis is that many borrowers did not understand the loans they were getting into, and that subprime lenders took advantage of this by offering loans that were doomed to fail and difficult to understand. A new study from the Atlanta Fed provides evidence in support of the borrower ignorance part of the narrative:
We find a large and statistically significant negative correlation between financial literacy and measures of mortgage delinquency and default, and the finding is robust to the inclusion of controls for income, education, risk aversion, and time preferences, thus ruling out a broad set of potential biases from omitted variables. The point estimates are remarkably robust, and quantitatively important: 20 percent of the borrowers in the bottom quartile of our financial literacy index have experienced foreclosure, compared to only 5 percent of those in the top quartile. Furthermore, borrowers in the bottom quartile of the index are behind on their mortgage payments 25 percent of the time, while those in the top quartile are behind approximately 10 percent of the time.
Concerns of a lack of basic financial literacy have led to calls for… well, more financial literacy. But this study suggests the problems go deeper than the inability to understand how to discount, or what an exploding balloon payment is, to a fundamental lack of numerical ability:
We include as control variables measures of other aspects of financial literacy and a general measure of cognitive ability, but find that the correlation is highly specific to one aspect of financial literacy: numerical ability.
Provocative question of the day: should mortgage applications come with a short IQ test, where potential borrowers receiving a score below a certain level are required to undergo extensive counseling to make sure they fully and completely understand the mortgage, payment schedule, and the all the issues it is assumed a borrower should understand?
4 comments
Comments feed for this article
Friday ~ May 7th, 2010 at 3:00 am
In Which I Say ‘Well, Maybe’… « It Don't Mean Much, These Seats are Cheap.
[...] } Adam Ozimek wonders: Provocative question of the day: should mortgage applications come with a short IQ test, where [...]
Friday ~ May 7th, 2010 at 3:55 am
Drscroogemcduck
It might not be because they don’t understand the loan. Innumerate people might be just generally bad with their finances. Maybe lenders should be giving higher rates to innumerate borrowers and lower rates to their numerate borrowers.
Friday ~ May 7th, 2010 at 8:58 am
Jim
What an utter waste of time.
People in the lowest quintile of financial literacy are behind in their mortgage payments, because the data to day decisions they make are bad, not because they are steered into unsuitable loans. I imagine the data on delinquency would be the same if we looked at rent, credit cards, cable and electric bills.
The even higher correlation with poor numerical abilities is further evidence of the well known fact (at least outside of academia and the Fed) that stupid people make bad decisions — in fact that is the number one observable symptom of being stupid. Being poor certainly doesn’t mean you’re dumb, but being dumb is a very good way to get poor, whether we’re in a world of IO Option ARMs or not.
A far more interesting study would be to measure credulousness versus delinquency. When every news outlet in the country is talking about how real estate can’t go down and home ownership is the road to wealth (as well as explicitly being linked to civic virtue in the media), am I more likely to go into default if I believe everything I read?
Friday ~ May 7th, 2010 at 9:19 pm
jazzbumpa
All of which misses a couple of vital points.
1) Lenders were aggressively hawking these loans to people who could not understand them, going so far as to hire fast-talking used car salesmen and telemarketers as pushers. When it’s pros vs amateurs, my money is on the pros.
2) A typical person going to a(n apparent and/or alleged) professional for a service rationally, though perhaps naively, expects professional quality service from a professional in a relevant field – like finance, not high-pressure sales. Many of these people were duped by people at major banking corporations who claimed to pride themselves on costomer service and satisfaction.
Yes, you can protect yourself by understanding basic math algorithms. No, you shouldn’t have to. I don’t know jack about ophthalmology, so I go to some one who has earned the right to hang that shingle.
Banking is just as important as vision correction, and needs effective and robust regulation. That is the preventive and the solution.
Cheers!
JzB