Settling the Debate: Payment Size Matters, Fed

Settling the Debate: Payment Size Matters, Fed


Throughout housing crisis, policymakers, industry participants, and laymen have argued the impacts of mortgage payment size on defaults, with individuals vehemently taking sides, claiming greed, neglect, and moral hazard lay in their opponent’s argument.

The Federal Reserve Bank of Boston recently conducted a study to clarify the effect of mortgage payment size on likelihood of default, and the researchers concluded “interest rate changes dramatically affect repayment behavior.”

Traditionally, “the prepayment option makes it impossible to use payment increases to measure the effects of payment changes,” the report reads. However, the Boston Fed was able to examine hybrid adjustable-rate mortgages (ARMs) that experienced payment declines during the recent economic climate.

Researchers compared homeowner payment behavior both before and after payment reductions and compared them to similar loans that did not receive simultaneous reductions.

“Our results show that the size of the monthly payment matters strongly for delinquency and cures, even for borrowers who are deeply underwater,” the Fed study states. “These findings, which we argue are consistent with theoretical predictions, shed light on the driving forces behind mortgage default and have a variety of policy implications.”

According to the findings, a payment reduction of about 2 percentage points results in a 50 percent decline in default probability. A 4 percentage point reduction decreases the likelihood of default by about 75 percent.

Even when applied to underwater borrowers, the Fed’s assertion that payment size plays an important role holds true. “Even severely underwater borrowers will be much more likely to cure if their interest rate is reduced substantially,” the report states.

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