Financial Literacy, Social Perception and Strategic Default

Abstract

As a result of sustained housing market fragility, a growing number of borrowers are walking away from their underwater homes even though they have the ability to pay. Despite recent advances, questions remain about what influences this decision. In this paper, we use survey data to examine the roles of social expectations, financial literacy and knowledge of default consequences. We find that homeowners who believe that others are likely to strategically default in the future are more willing to walk away as they anticipate reduced social stigma. Financially literate borrowers appear better able to calculate the benefits of strategically defaulting and are more willing to walk away at high levels of shortfall. We also find evidence that those who better understand the consequences of default, particularly that a default’s impact on one’s credit score weakens over time, have a higher willingness to walk away. Our results suggest that policies that help shape expectations about future strategic defaults may influence present foreclosures.