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?

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