Is there a psychological reason why people default on their mortgages?
A 2011 study, published in Psychological Science, found that people with bad credit scores are more impatient — more likely to choose immediate rewards rather than wait for a larger reward later.
The psychology of bad credit
The paper was written by two economists who were working at the Federal Reserve’s Center for Behavioral Economics and Decisionmaking in Boston at the time of the research. People at the Fed were very interested in understanding how the default crisis came about.
“Most often, the reasons economists put forward are, maybe there was not enough screening for mortgage applicants, or securitization, or other institutional reasons,” says Stephan Meier, of Columbia University. “That’s definitely important, but in the end, humans make those repayment decisions. So there must be more psychological factors that explain how people make those decisions to default or not?”
Delaying gratification key
During tax season, Meier and coauthor, Charles Sprenger, Stanford University, recruited 437 low-to-moderate income people at a community center in Boston that was offering tax preparation help. Each person was given a questionnaire in which they made choices between a smaller, immediate reward and a larger reward later.
This is a common test for seeing if people are willing to delay gratification. The questions offer different time periods and different amounts. The participants also agreed to let the researchers access their credit scores.
The study shows that time discounting and FICO scores were significantly correlated — more impatient people had lower credit scores — and that this correlation was comparable to previously found correlations between time discounting and health behavior. A low credit score can indicate some problems with credit in the past, like failing to pay bills or defaulting on a mortgage.
Participants who were the most willing to delay rewards and exhibited more patience had FICO scores that were approximately 30 points higher than those of participants who were the least willing to delay. Also, the impatient participants fell below the subprime lending cutoff of 620. At this score, individuals generally face substantially elevated borrowing rates.
“Conceptually, it does make sense that how people discount the future, i.e. how impatient they are, affects their decision to default on their loans,” Meier says. “Individuals accumulate debt and then have to decide whether to repay the money or use the money for something else.”
“Individuals accumulate debt and then have to decide whether to repay the money or use the money for something else.” If they don’t pay off their debt, they will have short-term benefits — any cash on hand is available for something else — but the costs/problems come much later, when a landlord, mortgage lender, or someone else sees their bad credit report.
The researchers acknowledge that defaulting on a loan isn’t always a deliberate choice. People may default for a variety of reasons, such as when they lose their job. However, as Meier explains, “There is a little bit of strategic defaulting going on, where some people make a cost-benefit analysis and choose to have more money now and deal with the repercussions later.”