The Basic Math Behind Subprime Foreclosures

The foreclosures that led to financial crisis began with homeowners falling behind on their mortgage payments. Yet, have all the factors behind the foreclosures been uncovered?

To date, much of the blame has been assigned to predatory lenders. However, a new and strikingly simple finding explains another significant factor. The Atlanta Federal Reserve has recently released a paper that shows that the numerical skill of homeowners has a meaningful impact on the rate at which they fell behind on mortgage payments.

According to The Economist:

“The economists tracked down a large number of subprime borrowers in New England on whom they already had detailed information, including the terms of their mortgages and their repayment histories. These borrowers were then subjected to a series of questions that required simple calculations about percentages and interest rates.

“Even accounting for a host of differences between people—including attitudes to risk, income levels and credit scores—those who fell behind on their mortgages were noticeably less numerate than those who kept up with their payments in the same overall circumstances. The least numerate fell behind about 25% of the time. For those who did best on the test, the number of payments they missed was almost 12%. A fifth of the least numerate group had been in foreclosure, but only 7% of those who were more numerically adept had.

“Surprisingly, the least numerate were not making loan choices that differed much from their peers. They were about as likely to have a fixed-rate mortgage as the more numerically able. They did not borrow a larger share of their income. And loans were about the same fraction of the house’s value.”

The Atlanta Fed has managed to show that homeowners that are better at these math skills tend to also be better at managing household finances. In and of itself, it’s a hardly surprising finding. However, it also goes to show that basic numeracy offers some ability to predict the outcome of subprime homeowners, much like other factors generally used to judge creditworthiness, such as income and credit scores. Maybe loan officers should start including a math test in their assessments.

You can visit The Economist to read more details on how subprime mortgage defaults resulted in part from the fear of all sums.


Rocky Vega,
The Daily Reckoning