Borrowers who strategically default on their first mortgage often continue to pay on home equity lines of credit, according to a new white paper from two authors with the Philadelphia Federal Reserve. Data for the study came from a large random sample of individual credit records drawn at the end of each quarter from Equifax, a national credit bureau.
Focusing on mortgage defaults, the white paper results indicate that the default rate for first mortgages far exceeded those of the second-lien mortgages during the current financial crisis. This behavior was not observed in the pre-financial crisis period (i.e., the booming period of 2004-2006).
About 20% of borrowers in the process of foreclosure due to defaults on the first mortgage kept their second-lien mortgage current. Among those who defaulted on their second-lien mortgages, about 80% also defaulted on their first-lien mortgage.
The data contradicts the hypothesis that consumers would strategically default on a second lien and keep their first lien current to reduce their monthly payment and thus avoid a foreclosure. Instead, a far larger number of households do the opposite; that is, they default on their first lien — thus risking a foreclosure — while keeping their underwater second-lien mortgages current.
The reason?
The authors hypothesized that borrowers have incentives to keep their second lien current — after having stopped paying their first mortgage — in order to maintain their access to credit through the HELOC.
The study also found that the size of the unused line of credit is an important factor. Homeowners with larger credit lines are less likely to default, as they are motivated to maintain their access to the credit line.
A large portion of first mortgages with estimated LTV (loan-to-value) ratios greater than 100% is still current, but the continued willingness and ability of these homeowners to make their mortgage payments is subject to great uncertainty.
The paper also noted that banks are not punishing borrowers who default on their first mortgages by limiting access to their home equity lines of credit. That could be due to poor risk management practices or lack of timely updates on consumer’s risk scores.
Given the large number of current homeowners with negative equity, there are likely a large number of borrowers who could default on their home equity loans without being forced into foreclosure.