Question

Mortgage lenders require the borrowers to make a 20% down payment. Otherwise, private mortgage insurance (PMI) is often required by mortgage lenders when the borrowers have less than a 20% down payment.1 Explain what type of asymmetric information problem these requirements help to solve?

Answer 1

Asymmetric information refers to the problem when one party has more information about the good or service than the other party

Asymmetric information generally leads to adverse selection and moral hazard and in the case of lending, the people who do not make down payment of at least 20% are more likely to default as the borrowers have more information than the lenders about their financial state and the lender does not know if the borrower will default on the loan so to protect himself against such situation or any foreclosure,he would ask the borrower to make at least 20% down payment or take private mortgage insurance which will make the borrowers less likely to default as they have a greater financial stake in the property.