This paper solves a dynamic model of a household’s decision to default on its mortgage, taking into account labor income, house price, inflation, and interest rate risk. Mortgage default is triggered by negative home equity, which results from declining house prices in a low inflation environment with large mortgage balances outstanding. Not all households with negative home equity default, however. The level of negative home equity that triggers default depends on the extent to which households are borrowing constrained. High loan-to-value ratios at mortgage origination increase the probability of negative home equity. High loan-to-income ratios also increase the probability of default by tightening borrowing constraints. Comparing mortgage types, adjustable-rate mortgage defaults occur when nominal interest rates increase and are substantially affected by idiosyncratic shocks to labor income. Fixed-rate mortgages default when interest rates and inflation are low, and create a higher probability of a default wave with a large number of defaults. Interest-only mortgages trade off an increased probability of negative home equity against a relaxation of borrowing constraints, but overall have the highest probability of a default wave.

Many different factors contributed to the global financial crisis of 2007-09. One such factor seems to have been the growing availability of subprime mortgage credit in the mid-2000s. Households were able to borrow higher multiples of income, with lower required down payments, often using adjustable-rate mortgages with low initial “teaser” rates. Low initial interest rates made the mortgage payments associated with large loans seem affordable for many households. The onset of the crisis was characterized by a fall in house prices, an increase in mortgage defaults and home foreclosures, and a decrease in the value of mortgage-backed securities. These events initially affected residential construction and the financial sector, but their negative effects spread quickly to other sectors of the economy. Foreclosures appear also to have had negative feedback effects on the values of neighboring properties, worsening the decline in house prices (Campbell, Giglio, and Pathak 2011). The crisis has emphasized the importance of understanding household incentives to default on mortgages, and the way in which these incentives vary across different types of mortgage contracts. This paper studies the mortgage default decision using a theoretical model of a rational utility-maximizing household.