Why borrowers resist using their homes as collateral

American households have most of their wealth in retirement savings (33%) and in their home…

American households have most of their wealth in retirement savings (33%) and in their home equity (29%). Of that, home equity exceeded $25 trillion, according to latest Federal Reserve data. Not surprisingly, homeowners with mortgage debt are loathe to give up their homes in foreclosures and may defy financial logic to avoid defaulting on their loans.

Two adults and a child watch a housepainter painting shutters on the front of the house.

Recent research on mortgage defaults show that home loan borrowers often continue making mortgage payments even when they are severely underwater, where the loan amount exceeds the value of their home. “Homeowners place a very high value on staying in their homes, sometimes at great cost to them by continuing to make mortgage payments, throwing good money after bad,” says Wharton real estate professor Benjamin Keys. In addition to the financial cost of defaulting, borrowers also face “a moral component” in terms of a stigma attached to defaulting and moving costs, he explains.

Naturally, homeowners are averse to posting their homes as collateral. For the first time, a research paper titled “The Cost of Consumer Collateral: Evidence from Bunching” by experts at Wharton and elsewhere has captured the degree of that aversion among homeowners to post their homes as collateral. Keys co-authored the paper with Benjamin L. Collier and Cameron Ellis, both professors of risk, insurance, and health care management at Temple University’s Fox School of Business; Collier is also a Wharton research fellow.

Determining that degree of “collateral aversion” is not possible from data on mortgage debt because most home loans require collateral in some form, notes Keys.

The researchers overcame that hurdle by finding a useful proxy in data from the Federal Disaster Loan program, which provides subsidized loans to households that have experienced a natural disaster (e.g., hurricane, tornado, wildfire) towards the repair of damage to their primary residence and the replacement of destroyed belongings. Under the program, those who borrow more than $25,000 have to post their primary residence as collateral. 

Analysis of the Federal Disaster Loan program data shows “how much borrowers hate posting collateral,” Keys notes. The research found that 30% of all borrowers “bunched” at the uncollateralized threshold of $25,000; loans bigger than that required them to put up their homes as collateral.

The analysis estimates the median degree of collateral aversion at 40%: When the threshold is $25,000, half of borrowers who were eligible to borrow $40,000 borrowed only $25,000, giving up $15,000 in subsidized credit. “Even homeowners who are currently underwater—and wouldn’t lose any equity if they defaulted—commonly bunch at the uncollateralized threshold,” Keys says. “The financial costs of default and the moral costs of default are the same regardless of collateral use, so the only thing that varies at the threshold is the fear of being kicked out of their homes.”

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