Why borrowers resist using their home as collateral

US households have most of their wealth in retirement savings (33%) and home equity (29%). Of that amount, home equity has exceeded $ 25 trillion, according to the latest data from the Federal Reserve. It’s no surprise that homeowners with mortgage debt are reluctant to give up their homes in the event of foreclosure and may defy financial logic to avoid defaulting on their loans.

Recent research on mortgage defaults shows that home loan borrowers often continue to make mortgage payments even when they are seriously underwater, when the loan amount exceeds the value of their home. “Homeowners place a very high value on staying in their home, sometimes at a high cost to them by continuing to make mortgage payments, spending a lot of money after the bad,” said Benjamin Keys, professor of real estate in Wharton. In addition to the financial cost of default, borrowers also face “a moral component” in terms of the stigma attached to default and moving costs, he explained.

Understandably, homeowners are reluctant to post their homes as collateral. For the first time, a research paper titled “The Cost of Consumer Collateral: Evidence from Bunching” written by experts from Wharton and elsewhere captured the degree of this aversion among homeowners to post their homes as collateral. Keys co-authored the article with Benjamin L. Collier and Cameron Ellis, both professors of risk management, insurance, and healthcare at the Fox School of Business at Temple University; Collier is also a researcher at Wharton.

Determining this degree of “collateral aversion” is not possible from mortgage debt data, because most home loans require some form of collateral, Keys noted. He put this in context: About 80% of all household debt in the United States is secured, and real estate secures about 90% of those loans.

Researchers overcame this hurdle by finding a useful indicator in data from the Federal Disaster Lending Program, which provides subsidized loans to households that have suffered a natural disaster (e.g., hurricane, tornado, fire in forest) to repair the damage caused to their main residence and the replacement of destroyed goods. Under the program, those who borrow more than $ 25,000 must indicate their primary residence as collateral. “This unique setting works as a near perfect experience to isolate the homeowners warranty value,” Keys said.

Degree of aversion to collateral

Analysis of data from the federal disaster lending program showed “how much borrowers hate providing collateral,” Keys noted. Research found that 30% of all borrowers “pooled” at the unsecured threshold of $ 25,000; loans larger than that required them to put their house as collateral.

The analysis estimated the median degree of aversion to collateral at 40%: when the threshold is $ 25,000, half of the borrowers who were eligible to borrow $ 40,000 only borrowed $ 25,000, dropping 15,000. $ in subsidized credit. “Even homeowners who are currently underwater – and would not lose any equity if they defaulted – typically band together at the unsecured threshold,” Keys said. “The financial costs of default and the moral costs of default are the same regardless of the use of collateral, so the only thing that varies at the threshold is fear of being evicted from their home. “

The data covered three periods of the federal disaster lending program between 2005 and 2018, during which the maximum unsecured loan amount increased from $ 10,000 to $ 25,000. For the period 2014-2018, 33% of borrowers opted for a loan of $ 25,000, although many qualified for much larger subsidized loan amounts.

“Homeowners place great importance on staying in their home, sometimes at a high cost to them by continuing to make mortgage payments, spending a lot of money after the bad one. ” –Benjamin Keys

“Adding up collateral aversion for all consolidators, we estimate that borrowers have given up over $ 1.1 billion in subsidized credit from this federal program in order to avoid posting collateral,” Keys said. “It wastes a lot of cheap credit. “

Keys clarified that just because 33% of borrowers band together at the threshold doesn’t mean the others aren’t reluctant. “It’s just that the benefits of the collateral outweigh the costs of consolidating by taking out a smaller subsidized loan. “

The document also found that default rates drop by 35% when loans are guaranteed. “This large magnitude is similar to improving a person’s credit rating by 100 points in terms of expected default,” Keys said.

Key takeaways for decision makers

One of the takeaways from the document for policymakers is the differential pricing option for secured and unsecured loans. “In a private market, we would expect competitive forces to require lenders to offer consumers something in return for putting their home back as collateral,” Keys said. “Given the large differences in default, we would expect lenders to be able to afford – on a risk-adjusted basis – to lower the interest rate for those providing collateral. This is what you would expect, if it was easier to collect the debt, expected loan losses would go down and interest rates would go down.

But under the federal disaster loan program, borrowers get nothing for putting their homes down as collateral. “One approach policymakers could take would be to lower interest rates and lower borrowing costs for those who guarantee their loans. This would encourage more people to post collateral – thereby reducing pooling – and reduce defaults in the program, even with larger loans. This could be a way to more accurately assess the risk and potentially attract more people to the program. “