June 27, 2019, (Washington, DC) – The JPMorgan Chase Institute today released new research indicating that three mortgage payments of post-closing liquidity was the key to homeowners preventing mortgage default across all income levels, suggesting 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.
Contrary to the conventional wisdom that larger down payments, and therefore lower loan-to-value (LTV) ratios, reduce default rates, a program 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.
Borrowers with less than one mortgage payment equivalent (MPE) of post-closing liquidity had a three-year default rate (1.8 percent) that was more than five times higher than borrowers with between three and four MPEs of post-closing liquidity (0.3 percent). Further, default rates for borrowers with 2 percentage points less in equity at origination but the equivalent of three to four MPEs in cash reserves had default rates that were an average of 1.4 percentage points lower than default rates for borrowers with little liquidity.
“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 new report, Trading Equity for Liquidity: Bank Data on the Relationship between Liquidity and Mortgage Default, analyzed a sample of de-identified Chase customers who had both a Chase mortgage and Chase deposit account, observing borrowers’ checking and savings account balances to determine liquidity shortly after closing and over the life of the mortgage. The research then examined how default rates differed for borrowers with various levels of liquidity.
Key findings from the report include:
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. Therefore, trading equity for more liquidity at origination may reduce default rates.
- Borrowers with less than one MPE of liquidity just after closing defaulted at rates that were five times higher than borrowers with three to four MPEs of liquidity.
- Borrowers with little liquidity made up a disproportionately high share of defaults. Homeowners with less than one MPE of post-closing liquidity made up 20 percent of our sample but accounted for 54 percent of defaults.
- 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.
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.
- For homeowners who defaulted, default was preceded by a drop in income regardless of whether their total DTI at origination was above or below the 43 percent ability-to-repay threshold of the Qualified Mortgage rule.
- 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 ten percent payment reduction (increase in liquidity) reduced default rates by 22 percent.
- 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 to 33 percent payment reduction for one year and help them avoid default.
Click here to read the report.
About the JPMorgan Chase Institute
The JPMorgan Chase Institute is a global think tank dedicated to delivering data-rich analyses and expert insights for the public good. Its aim is to help decision makers–policymakers, businesses, and nonprofit leaders–appreciate the scale, granularity, diversity, and interconnectedness of the global economic system and use timely data and thoughtful analysis to make more informed decisions that advance prosperity for all. Drawing on JPMorgan Chase & Co.’s unique proprietary data, expertise, and market access, the Institute develops analyses and insights on the inner workings of the global economy, frames critical problems, and convenes stakeholders and leading thinkers. For more information visit: JPMorganChaseInstitute.com.