We tend to undervalue the future. Nowhere is this tendency stronger than in finance, and nowhere in finance is it stronger than in the mortgage market. Borrowers focus on the monthly payment, because that is today’s problem, to the neglect of how much they owe and the future obligations they may face, because those are tomorrow’s problems. I have termed this "payment myopia."
The system encourages payment myopia. Like all salespeople, loan officers and mortgage brokers sell an alluring present, not a challenging future. Lenders have created instruments that support their efforts by offering reduced payments in the early years at the cost of higher payments and larger balances in later years.
The most radical of these was the so-called option ARM, an adjustable-rate mortgage that allowed borrowers to make payments that did not cover the interest for five years — and in some cases 10 years — before the hammer fell. Since the crisis erupted in 2007, the default rate on option ARMs has been so horrendous that they are no longer being written. But payment myopia continues.
Today, the instrument that most appeals to the payment-myopic is the interest-only (IO) mortgage. On IOs, the borrower pays only interest in the early years, usually for 10 years.
All adjustable-rate mortgages have an IO version, as does the 30-year fixed-rate mortgage. There are some defensible reasons for selecting an IO, which I discussed in a recent article, but most borrowers who take them do it for the lower payment in the early years, to the neglect of the future. That’s why I don’t like IOs.
Recently I have begun to think about possible ways to overcome payment myopia, other than preaching, which I know from personal experience doesn’t work.
I was provoked by a recent discovery of a method of inducing more employees to sign up for retirement plans offered by their employers. That a large proportion did not take advantage of plans that were highly advantageous to them was another manifestation of the general tendency to undervalue the future. Underfunding retirement plans and payment myopia have the same roots in the human psyche.
It was discovered that if new employees, instead of being offered an opportunity to join the retirement plan, were automatically entered and given an opportunity to opt out, the participation rate increased dramatically. Is there a comparable technique, I wondered, that might induce mortgage borrowers to give greater weight to the future in their mortgage decisions?
Part of the reason why borrowers discount the future so heavily in making mortgage decisions is that the future is not as clearly seen as it could be. As a general rule, the right type of mortgage for John Doe is the one with the lowest total cost for Doe.
The total cost is a borrower-specific number, because it depends on how long the borrower expects to have the mortgage, his investment rate and his tax rate. Total cost is the sum of all monthly payments of principal and interest, points and other settlement costs paid upfront, lost interest on monthly and upfront payments, less tax savings and balance reduction. …CONTINUED
But Doe does not know the total cost of the various mortgages he is offered because nobody calculates it for him. He knows the starting mortgage payment very well because it is shown on multiple documents. Hence, what should be a limiting condition — the starting payment must be affordable — for all too many borrowers becomes the only thing they look at in making a selection.
Here is an illustration using an IO, which as I noted above has a strong appeal to payment-myopic borrowers. On Feb. 10, a prime borrower could have had a $300,000, 30-year fixed-rate mortgage at 4.875 percent, or an IO version of the same loan at 5.5 percent.
The payment on the first was $1,587, and on the IO it was $1,375, a difference of $212 a month. Over 10 years, that amounts to a saving of $25,516.
In addition, assuming the borrower can earn 2 percent on his money and is in the 27 percent tax bracket, the interest loss on payments is $1,939 smaller on the IO, and the tax savings at 27 percent is $9,020 higher. This adds to a total of $36,475 in "savings" on the IO.
But, at the end of 10 years, the borrower will still owe $300,000 on the IO, and only $243,101 on its fully amortizing counterpart, which is a balance reduction of $56,899. Bottom line: The total cost is $20,424 larger on the IO.
Oh, yes, let’s not forget that in month 121, the payment on the IO jumps from $1,375 to $2,064, where it remains for the next 20 years. The fruits of payment myopia are indeed bitter.
So how does a borrower who is determined not to be payment-myopic find the total cost of different mortgages? Don’t expect to get it from your loan provider. If you have all the necessary details about the alternative mortgages, you can calculate the total cost to you of each mortgage using my calculator 9ai.
The only online source that will calculate the total cost for you automatically is www.home-account.com, in which I have a financial interest. Their commitment to provide the borrower-specific total cost of every loan was part of my deal with them.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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