Time Preferences, Mortgage Choice and Mortgage Default

Abstract

The global economy is in the midst of a recession triggered by the ongoing pandemic of a novel coronavirus disease (COVID-19). The shutdown of the economy and a surge in the unemployment rate also cause stress to the US housing and mortgage system and create significant impacts on the default behaviour of mortgage borrowers. The potential rise in mortgage defaults may renew the long-standing debate over the empirical observation of why some mortgage borrowers do not default as “ruthlessly” as the finance theory predicts. In this paper, we propose an alternative theory to explain for the different default behaviours among mortgage borrowers. We hypothesize that the difference among time preferences across mortgage choices is one of the underlying factors that causes the heterogeneity in default patterns. Borrowers can either have a present-biased preference (overvaluing immediate outcomes), or a time-consistent preference (with 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 an adverse shock, such as the one from the ongoing pandemic, occurs.

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