Most lenders would agree that, up until the end of 2007 or so, consumers generally followed a traditional payment hierarchy. In times of financial distress, a consumer would typically stop paying a credit card first, an auto loan next and a mortgage last. Over the past five years, an interesting shift in this payment hierarchy has been observed. It is important for lenders to understand those forces influencing consumer behavior, so they can engage their customers and prospects effectively and to mutual benefit — particularly when the environment continues to challenge both lenders and consumers alike.
The traditional payment hierarchy was not random. Rather, it developed due to clear forces in the marketplace. To begin with, credit cards were readily available. Having one credit card closed due to nonpayment might make access to additional credit cards more expensive, but would not generally reduce that access materially. There also was generally no physical consequence of credit card default. In contrast, auto loan default and home foreclosure both lead to repossession.
Consider also that the traditional down payment for a home was 20%. Most consumers had to work for years to save enough to meet that goal. Thus, homeownership was both a financial achievement and a psychological achievement. And remember, the social stigma of foreclosure was significant. In short, there were compelling reasons the average consumer would choose to default first on a credit card and only as a last resort on a mortgage.
To understand the change in the payment hierarchy, we developed a study that incorporated quarterly data on over five million consumers from Q2 2007 through Q4 2011. The analysis of mortgage and bankcard delinquency trends cover this entire time period, while auto loan data was incorporated as of Q1 2011 through the end of the year.
When analyzing the ratios of consumers delinquent on one of the three primary products versus the others, we found that in Q1 2008 the percentage of consumers current on bankcards but delinquent on mortgages surpassed the percentage of consumers current on mortgages but delinquent on bankcards. This "flip" in the traditional payment hierarchy is representative of a change in how consumers choose to pay their debt obligations. We found that this payment hierarchy reversal has persisted at least two and a half years after the end of the recession and for four years in total.
The story becomes even more interesting when auto loans are included. Of those consumers who were 30-plus days past due on only one of the three primary products, only 9.5% were delinquent on an auto loan while current on their credit cards and mortgages. 17.3% were delinquent on a credit card only, while 39.1% were delinquent on a mortgage only. Clearly, the payment preference for consumers with all three loan types is to prioritize auto loans ahead of their mortgages and bankcards.
What drove this change? One contributing factor is that credit card lenders became much more conservative in their underwriting standards, so cards were harder to acquire. Concurrently, auto values became stronger, while home equity has largely evaporated. Foreclosure has become far more socially acceptable. Perhaps most importantly, unemployment has been stubborn, stimulating the need for credit card liquidity to make ends meet.
We found that the preference to pay credit cards ahead of mortgages is strongly correlated to both unemployment and home value depreciation. This correlation to economic factors is actually encouraging news. It implies that changes in customer preferences and performance can be explained. It also implies that once the drivers of the hierarchy reversal abate, consumer preferences are likely to revert to the traditional prioritization.
The conventional wisdom has always been that consumers will pay their mortgages first when faced with financial distress. The results of this analysis show that the traditional payment hierarchy has changed, and for understandable reasons. Lenders using historical payment models to set strategy or, even worse, relying on experience and intuition rather than data-driven analytics, risk both significant exposure on their existing loan portfolios and the loss of acquisition opportunities when consumer preferences inevitably shift again.
Ezra Becker is vice president of research and consulting in the financial services business unit of TransUnion. Matt Komos is formerly a senior solutions consultant in the analytical services group at TransUnion.