Time Preferences, Mortgage Choice and Mortgage Default

42 Pages Posted: 11 Jun 2014 Last revised: 14 Sep 2014

See all articles by Sumit Agarwal

Sumit Agarwal

National University of Singapore

Yongheng Deng

Wisconsin School of Business, University of Wisconsin-Madison

Jia He

Nankai University

Date Written: September 14, 2014

Abstract

The recent financial crisis has led to calls for a better understanding of the reasons behind the increase in mortgage defaults and the foreclosures that followed. Previous studies using option-based mortgage default models predicted that borrowers should immediately exercise the default option when the market value of their mortgage exceeds the value of the underlying property. However, empirical evidence shows that a substantial number of borrowers are unlikely to default as 'ruthlessly' as the option theory predicts. This indicates that mortgage borrowers are a heterogeneous group. In this paper, borrowers’ time preferences across mortgage choices are hypothesized as being heterogeneous. Borrowers can either have a present-biased preference (overvaluing immediate outcomes), or a time-consistent preference (standard exponential discounting). Borrowers with a present-biased preference are more likely to accept back-loaded mortgages that minimize up-front costs, even though this increases their risk of going "underwater" and entering default when negative home price shocks occur.

Keywords: Mortgage default, mortgage choice, heterogeneity, present-biased preference, dynamic inconsistency

JEL Classification: D1, D9, G1, R2

Suggested Citation

Agarwal, Sumit and Deng, Yongheng and He, Jia, Time Preferences, Mortgage Choice and Mortgage Default (September 14, 2014). Available at SSRN: https://ssrn.com/abstract=2447684 or http://dx.doi.org/10.2139/ssrn.2447684

Sumit Agarwal

National University of Singapore ( email )

15 Kent Ridge Drive
Singapore, 117592
Singapore
8118 9025 (Phone)

HOME PAGE: http://www.ushakrisna.com

Yongheng Deng

Wisconsin School of Business, University of Wisconsin-Madison ( email )

4110 Grainger Hall
975 University Avenue
Madison, WI 53706
United States
+1 (608) 262-4865 (Phone)

HOME PAGE: http://https://bus.wisc.edu/faculty/yongheng-deng

Jia He (Contact Author)

Nankai University ( email )

94 Weijin Road
Tianjin, 300071
China

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