For years, the conventional wisdom in mortgage lending has been borrowers with more financial skin in the game are less likely to default on their mortgages.
The thought is when borrowers put down a larger down payment, they are more financially stable and therefore will be able to continue paying on their mortgages. Also, with more of their own money on the line, borrowers would be less likely to simply walk away from their home, like so many did after the financial crisis.
It’s the reason why so many people were worried when Fannie Mae and Freddie Mac rolled out programs where they’d buy and guarantee mortgages that only required 3% down from the borrower.
But new research from JPMorgan Chase suggests that borrowers putting more of their money down for a home is not actually a solid way to prevent them from defaulting on their mortgages.
Rather, the research states that allowing borrowers to keep more money in the bank instead of putting that money down will help borrowers pay their mortgages and keep them in their homes.
Put simply, borrower liquidity appears to be more important than borrower equity.
The research, released this week by the JPMorgan Chase Institute, shows borrowers that having three mortgage payments worth of post-closing liquidity (meaning they have three mortgage payments worth of money in the bank) was the “key to homeowners preventing mortgage default across all income levels.”
According to the research, this suggests that “liquidity is a more useful predictor of mortgage default than home equity, income level, and payment burden—especially for borrowers with limited liquidity at closing.”
The report shows that despite the traditional thought that larger down payments, and therefore lower loan-to-value ratios (higher borrower equity in the property) lead to lower default rates, allowing homeowners to “maintain a higher level of liquidity by providing a slightly smaller down payment at origination and keeping the residual cash in a reserve account, for use in the case of financial distress, may lead to lower default rates.”
And the report is not simply based on conjecture.
JPMorgan Chase’s analysts looked at a sample of de-identified Chase customers who had both a Chase mortgage and Chase deposit account, making note of the borrowers’ checking and savings account balances to determine their liquidity shortly after closing and over the life of their mortgage.
The research then examined how default rates were different for borrowers with various levels of liquidity.
And the research determined that borrowers with smaller amounts of liquidity defaulted at “considerably higher rates” than those with greater liquidity regardless of their home equity, income level, or monthly mortgage payment amount.
According to the report, borrowers with less than one monthly payment in the bank just after closing defaulted five times more frequently than borrowers with three to four months worth of mortgage payments in the bank.
Per the report, borrowers with less than one mortgage payment of post-closing liquidity had a three-year default rate of 1.8%, which was more than five times higher than the default rate of borrowers with between three and four monthly payments of post-closing liquidity, 0.3%.
Additionally, the report showed that borrowers with smaller amounts of liquidity made up a “disproportionately high share” of mortgage defaults.
According to the report, borrowers with less than one month of mortgage payment liquidity made up 20% of the sample but accounted for 54% of the defaults.
The report also shows that underwriting standards that rely on the borrower meeting a debt-to-income ratio threshold may not be an effective or fully safe method of determining a borrower’s ability to repay their mortgage.
That’s because, according to Chase’s analysis, total DTI at origination “does not account for future income volatility or measure a household’s ability to withstand that volatility.”
In most cases, for the observed borrowers, the ones that defaulted on their mortgage typically saw a drop in income prior to default regardless of whether their total DTI at origination was above or below the 43% ability-to-repay threshold of the Qualified Mortgage rule.
Along those same lines, Chase observed that mortgage modifications that reduced their mortgage payment (and therefore increased their liquidity) reduced default rates compared to modifications that increased borrower equity but left them underwater on their loan.
According to the report, a 10% payment reduction reduced default rates by 22%, while modifications that relied on principal reduction had “no material impact on default rates for borrowers who remained underwater.”
To avoid defaults, Chase suggests that borrowers should consider setting aside three to four months of mortgage payments (if possible) in a mortgage emergency account to use in case of a loss of income or other financial event. Beyond that, Chase suggests that lenders should focus more on what the borrower has left in the bank after the fact rather than simply how much they can put down upfront.
“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.”