Different mortgage types default at different times
Both fixed-rate and adjustable-rate mortgages are susceptible to default, though at different times when the right amount of economic volatility shakes the financial markets, according to a new report from the National Bureau of Economic Research. However, the factors that end up leading each type of mortgage into default are often quite different. The NBER is a private, non-profit research organization known for using its economic data and analysis to predict the start and end dates of recessions and recoveries in the national economy. The latest research report, written by John Campbell an economics professor at Harvard University and João Cocco an economics researcher at London Business School, looks to create a housing model that predicts when a borrower is more likely to default on their mortgage. The study finds that fixed-rate mortgages default the most when inflation and interest rates are low. On the flip side, adjustable-rate mortgages perform the best when interest rates are down. The risk factor for ARMs rise when interest rates increase, as these loans are more susceptible to shocks that directly impact borrower income levels. The study from NBER also found high loan-to-value ratios increase the probability of default by tightening borrowing constraints. By way of comparison, interest-only mortgages have the highest probability of experiencing a default, the NBER found. The default rates for balloon mortgages, such as IOs, are less sensitive to drops in house prices in the early years of the loan, but more sensitive to the longer-term evolution of house prices. "We find that the relaxation of borrowing constraints dominates early in the life of the mortgage," the authors wrote. "But default rates become larger than for principal-repayment mortgages late in the life of the mortgage due to the considerably higher probability of negative home equity." Defaults tend to occur when a home enters a negative equity state, which is usually caused by several factors, including home price declines in a low inflation environment and large mortgage balances with little money down at the time of origination. However, after looking at mortgage default trends in other countries as well, Campbell and Cocco found that there is a variable lag time to when negative equity hits and the borrower stops making payments. In that regard, they find the strength of a household's survival generally depends on whether the homeowners are borrowing constrained and their current savings level. Putting little down at the time of origination greatly increases the probability of default, the report concluded, with that probability increasing even more for loans with LTV ratios in excess of 90%. Write to Kerri Panchuk.