Association for Public Policy Analysis & Management

In previous research, the JPMorgan Chase Institute found that a 10 percent mortgage payment reduction reduced default rates by 22 percent, whereas for borrowers who remained underwater, principal reduction had no effect on default or consumption. These results imply that short term liquidity was a key factor driving mortgage default. In this follow-up report, we used mortgage data at the borrower level joined to deposit account data to further examine the relationship between income shocks, financial buffers, and mortgage default.

We find that for homeowners who defaulted, a substantial negative income shock preceded their default regardless of their home equity level, income level, or total debt-to-income ratio at origination. Deeper and longer duration negative income shocks were associated with increasing delinquency. To the extent their income recovered quickly, homeowners were quickly able to resume making their mortgage payments, while homeowners with larger financial buffers used their cash reserves to delay mortgage default following a negative income shock. Homeowners with larger financial buffers had lower default rates regardless of their income level or total debt-to-income ratio.

Taken together, these findings highlight the important connection between a negative income shock and default, and suggest that providing borrowers with incentives to build and maintain a post-purchase financial buffer may be a more effective approach to default prevention than underwriting standards based on meeting ability-to-pay rules at origination.