Subprime Borrowers With Poor Financial Literacy Are More Likely To Default, Report Says

Filing for foreclosure may trim hundreds of points off of a credit score and remain on a report for seven years.

Many consumers have no option but to face this fate, as high unemployment and diminished home equity have left them with little in the way of liquid assets. Improving their financial literacy, however, may be useful in avoiding this situation in the first place, according to a recent report by the Federal Reserve Bank of Atlanta.

Researchers looked at borrowers who took out subprime mortgage loans in 2006 and 2007 - the years leading up to the recent real estate crisis - and measured their financial literacy and cognitive ability. From there, they sought a possible correlation between these factors as well as the likelihood to default on the loans.

Those who scored the highest for financial literacy and numerical skills were two-thirds less likely to fall into foreclosure, according to the report. Members of this group also spent an average of 12 percent of their time in delinquency, compared to the 25 percent of time endured by those within the lowest scoring group.

The report also showed that loans taken out by individuals with low financial literacy or cognitive ability were no less favorable than those obtained by their high-scoring counterparts. Their financial missteps materialized in other ways.

"This suggests that limited numerical ability might lead to other mistakes over the course of time, like too much spending, too little savings, or inappropriate reaction to income and/or consumption shocks," the report said. "Such an interpretation is consistent with results using the same measure of numerical ability for savings and related measures."

The National Community Reinvestment Coalition also conducted a report to investigate which parts of the population were more likely to foreclose upon their mortgage loans. Researchers found that African-Americans and Latinos living in the District of Columbia were significantly more likely to both obtain subprime loans and file for foreclosure than their white counterparts.

While they are equally damaging to one's credit score, the alternatives to foreclosure may have a smaller impact on one's overall finances. Distressed homeowners who surrender their home through a short sale are often able to cancel the remaining balance on their loan, while those who use deed-in-lieu foreclosures may escape debt more quickly.

by: Krystle Chelsea Chan

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