Financial Literacy and the Subprime Crisis

A new working paper from the Atlanta Fed identifies a key reason why some subprime mortgage borrowers have defaulted and some haven’t: differences in numerical ability (ht: Torsten S.).

In “Financial Literacy and Subprime Mortgage Delinquency,” Kristopher Gerardi, Lorenz Goette, and Stephan Meier examine how the financial literacy of individual subprime borrowers (as measured through a survey) relates to mortgage outcomes. They find a big effect:

Foreclosure starts are approximately two-thirds lower in the group with the highest measured level of numerical ability compared with the group with the lowest measured level. The result is robust to controlling for a broad set of sociodemographic variables and not driven by other aspects of cognitive ability or the characteristics of the mortgage contracts.

20 percent of the borrowers in the bottom quartile of our financial literacy index have experienced foreclosure, compared to only 5 percent of those in the top quartile. Furthermore, borrowers in the bottom quartile of the index are behind on their mortgage payments 25 percent of the time, while those in the top quartile are behind approximately 10 percent of the time.

Interestingly, this effect is not due to differences in the mortgages that borrowers selected (e.g., it’s not that the less-numerically-able chose systematically bad mortgages*) or obvious socioeconomic factors (e.g., it’s not that the less-numerically-able had lower incomes).

Instead it appears that the less-numerically-able are more likely to make financial mistakes once they have their mortgages. As the authors note, this conclusion is consistent with other studies that examine how financial literacy relates to saving and spending choices over time. All of which is further evidence of the potential benefits of better financial (and numerical) education.

* The authors note one caveat on the conclusion about mortgage terms: The survey covered “individuals between 1 and 2 years after their mortgage had been originated,” but many subprime defaults happened more quickly than that. As a result, their results don’t address whether financial literacy played a role in determining which borrowers ended up in mortgages that blew up very rapidly.

7 thoughts on “Financial Literacy and the Subprime Crisis”

  1. I’m gonna go out on limb here and say a similar corollary could be found between defaults and income level/debt level. I bet people with higher incomes and lower debt levels, default less.

    So if you understand finance better, you will understand what you are getting into when you take out a loan. Amazing, I would never have thought such a thing could be true.

    I’ll take a side bet, that people that are unemployed, buy fewer homes. Or at least they do now that you can’t get liar loans.

    Why so much analysis of obvious minutiae, whilst the obvious fraud of Wall Street and mortgage industry and rating agencies goes largely unwritten about on your blog? Is it that you just don’t care, don’t understand it, or just don’t realize what happened to our economy is not a normal recession?

  2. I find the paper very interesting.

    1. Q5 in section B.1 should specify the “rest” period for the savings account.

    2. That only 13% gave correct answers to all five questions indicates an astonishing lack of numerical ability among the remaining 87% of borrowers. No doubt they blame Wall Street and Goldman Sachs.

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