Time Preferences, Mortgage Choice and Mortgage Default

The recent financial crisis has led to calls for a better understanding of the reasons behind the increase in mortgage defaults and the foreclosures that followed. Previous studies using option-based mortgage default models predicted that borrowers should immediately exercise the default option when the market value of their mortgage exceeds the value of the underlying property. However, empirical evidence shows that a substantial number of borrowers are unlikely to default as 'ruthlessly' as the option theory predicts. This indicates that mortgage borrowers are a heterogeneous group. In this paper, borrowers' time preferences across mortgage choices are hypothesized as being heterogeneous. Borrowers can either have a present-biased preference (overvaluing immediate outcomes), or a time-consistent preference (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 negative home price shocks occur