Research finds a stronger indicator of defaults than many other factors
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When determining the risk of a borrower defaulting on their mortgage, lenders and servicers may use factors including home equity, income level, and payment burden.
But recent research by the JPMorgan Chase Institute reveals that liquidity is perhaps a better measure, specifically borrowers having three months of mortgage payments available.
This snaps conventional wisdom that larger down payments cut default rates due to the lower LTV ratio; and suggests that a program allowing homeowners to make a slightly lower down payment but bank residual cash in a reserve account, may help cut default rates.
“Understanding the principal factors associated with mortgage default is critically important to developing solutions that help Americans avoid default and stay in their homes,” said Diana Farrell, President and CEO, JPMorgan Chase Institute. “We hope this analysis is valuable in helping mortgage lenders and servicers develop policies and programs that could prevent defaults in the future, while also helping more people access mortgages and have the opportunity to own a home.”
The research noted that underwriting standards that rely on meeting a debt-to-income (DTI) threshold at origination may not be the most effective method for reducing mortgage default, as total DTI measured at origination does not account for future income volatility or measure a household’s ability to withstand that volatility.
In fact, the analysis of Chase customers’ mortgage accounts found that among those that defaulted, default was preceded by a drop in income regardless of whether their total DTI at origination was above or below the 43% ability-to-repay threshold of the Qualified Mortgage rule.
Other findings
The report - Trading Equity for Liquidity: Bank Data on the Relationship between Liquidity and Mortgage Default – found that borrowers with little liquidity defaulted at considerably higher rates than those with greater liquidity regardless of their home equity, income level, or monthly mortgage payment burden.
- Those with less than one mortgage payment equivalent (MPE) of liquidity just after closing defaulted at rates that were five times higher than borrowers with three to four MPEs of liquidity.
- Default rates for borrowers with a 2-percentage-point higher LTV (less equity) but three-to-four MPEs in cash reserves (more liquidity) at origination had three-year default rates that were an average of 1.4 percentage points lower than default rates for borrowers with little liquidity.
- Across all levels of total DTI at origination, half of homeowners who defaulted had fewer than 1.4 MPEs of liquidity, and the median homeowner who did not default had more liquidity than those who did.
- Mortgage modifications that increased borrower liquidity reduced default rates, whereas modifications that increased borrower equity but left them underwater did not impact default rates.
- A 10% payment reduction (increase in liquidity) reduced default rates by 22%.
- Modifications that relied on principal reduction (an increase in equity) had no material impact on default rates for borrowers who remained underwater.
- A financially distressed homeowner could use an emergency mortgage reserve account to provide themselves with a temporary payment reduction in the same way a mortgage modification would, through increased liquidity.
Funded with three to four MPEs of liquidity, an emergency mortgage reserve account could provide a distressed homeowner with a 25-33% payment reduction for one year and help them avoid default.
