Financial Literacy and Mortgage Credit: Evidence from the Recent Mortgage Market Crisis
52 Pages Posted: 18 Jul 2015
Date Written: July 15, 2015
We use a novel approach to calculate individual “financial literacy score” for a large set of California mortgage borrowers and then investigate the relation between financial literacy and mortgage outcomes. We find borrowers with low financial literacy are more likely to accept riskier mortgages and have mortgages with disadvantageous characteristics, ceteris paribus. In addition, they pay a higher rate, are less likely to take advantage of advantageous prepayment opportunities, and are more likely to default. Our estimates show that financial literacy is economically significant where mortgage outcomes are concerned. Our lower-bound estimate is that converting low literacy borrowers into high literacy borrowers would lead to $460 million in reduced mortgage payments annually in California due to reduced borrowing cost. Other reasonable scenarios yield savings exceeding $2 billion annually. Further, with improved financial literacy, borrowers would be 25 to 50 percent less likely to have the “toxic” short-term adjustable rate mortgages that contributed to the broader housing crisis. Our results argue for serious consideration of how best to improve financial literacy, as opposed to whether efforts should be made to improve financial literacy.
Keywords: financial literacy, mortgage credit, mortgage choice, borrowing cost, default, prepayment
JEL Classification: G21, D12
Suggested Citation: Suggested Citation