A simple math test can predict who will default on a subprime mortgage, which isn’t good news for the numbers-phobic.
The test was part of research published in the Proceedings of the National Academy of Sciences that included data from 74,000 mortgages in New England and a phone survey involving 339 of those mortgage holders.
The volunteers who agreed to take part answered a half-hour phone interview and took a basic math test. The mortgages in the study had all been initiated in 2006 or 2007— and more than half of all subprime home loans taken out in those years were in default within five years. Around two-thirds of the homeowners in the study had adjustable rate loans.
The math problems involved relatively simple queries such as calculating how many people out of 1,000 would catch a disease that affects 10% of people. The hardest question involved compound interest. Those who scored in the lowest performing group were delinquent on their loans for almost 25% of the time they had them— while those in the highest fell behind just 12% of the time.
“It doesn’t seem that people who are bad at performing calculations got into particularly complicated mortgages and then defaulted,” says study author Lorenz Goette, professor of economics at the University of Lausanne in Switzerland. “We don’t find that these people get systematically worse contract conditions like prepayment penalties [which can preclude refinancing]. Our research shows that the probability of default is higher if you almost literally can’t put two and two together.”
Even after Goette and his colleagues adjusted for other factors like income, education and credit score that can influence mortgage default rates, the connection between poor math skills and higher defaults did not change much. Most of the mortgage holders were financially comfortable, reflecting a relatively high education level and average household income of $80,000, which is significantly above the $54,000 median household income for the U.S. at the time. About half of the mortgagees were women. The fact that credit scores didn’t matter also suggests that the study wasn’t simply picking up that fact that people who defaulted in the past were more likely to do so in the future. Instead, says Goette, it’s likely finding the effect of math skills.
“It could be that gradually their budget gets out of control,” he says, offering a potential explanation for why these people were at higher risk of defaulting, despite their relatively reasonable terms. “Maybe they mess up other contracts or maybe their medical expenditures get out of control. We find a strong association, but we can’t pin it down to particular behavior.”
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The study also found that verbal IQ didn’t matter in terms of mortgage delinquency — however, it did make a difference in foreclosure. “[This] makes perfect sense: if you’re quick on your feet, you probably can negotiate better with the bank,” says Goette.
At some level, the findings aren’t surprising. After all, says Helaine Olen, author of Pound Foolish: Exposing the Dark Side of the Personal Finance Industry, “It’s been well known that people who are better at math have better financial outcomes.” But research such as this can hopefully point to ways that people with weaker math skills can be helped to prevent them from defaulting and losing precious property. One possibility: better financial education. A recent study that found that increasing such opportunities in high school improved income and savings over the long term. They also note that some studies suggest that math skills rely far less on innate talent than was previously believed, giving the math-challenged motivation that they can learn their way out of their numbers-block.
Olen says that while such education is a good start, it may not be enough when it comes to keeping people on good terms with their bank. “We have this issue where we’re constantly looking for individual solutions for global problems,” she says. “This was not a problem in 1979 or 1980. Odds are not that math skills have changed much. What has changed is the availability of a different type of mortgage.”
Unless we’re willing and able to re-regulate the financial system, however, that won’t change. So in the meantime, it’s one more reason to make sure your kids do their math homework— and understand it.