As noted last week, borrowers often make costly transactional mistakes because they know less than the loan providers they deal with, who are motivated to exploit their information advantage. A borrower who pays 5 percent -- when she could have gotten 4.875 percent if she had known what her loan provider knew -- has made a transactional mistake.
Borrowers make lifestyle mistakes for the same reason, and also because lifestyle decisions are often complicated and borrowers tend to overweight short-term benefits and underweight long-term costs. A borrower who refinances to reduce her payment at the cost of owing substantially more after five years may have made a very costly lifestyle mistake.
Lenders have no financial incentive to reduce borrower mistakes, and government efforts have been largely ineffective. This article will describe a private-sector initiative using a system based on advanced Internet technology that can eliminate the causes of borrower mistakes. I will call this system EQ.
The potential borrower -- I'll call him "Adam" -- logs in to EQ and fills out an information form that is a little longer than those found on other mortgage Web sites. EQ needs to know more about Adam because it calculates a cost of borrowing that is specific to him -- unlike the government-mandated measure called APR (annual percentage rate) that assumes "one size fits all."
I discussed the need for this kind of measure in a recent article and called it "time horizon cost," or THC. EQ also collects credit information about Adam from a credit bureau.
EQ gives Adam a listing of all mortgage programs for which Adam qualifies, listed in order of Adam's THC. EQ will also show the payment, which Adam must find affordable, and on adjustable-rate mortgages it will show the THC and payment on different assumptions regarding future interest rates so Adam can assess the risk of future rate increases.
This information is compiled for every individual lender on EQ's network, so in selecting the best mortgage Adam is also selecting the lender providing the best terms on that mortgage. EQ allows Adam to avoid transactional mistakes and lifestyle mistakes at the same time.
EQ has another piece of information for Adam that could prove invaluable. If the prices Adam qualifies for are not the lowest available in the current market, EQ will display the best prices and where Adam falls short. It could be too low a credit score, too much debt, too small a downpayment, insufficient cash reserves, or some combination of these.
This might induce Adam to take a detour, delaying the loan while working to improve his credentials. If he takes the detour, EQ will guide him on what must be done.
If Adam wants to go ahead, he requests the lender offering the best terms on the desired loan to lock the price. The lender might or might not be willing to lock based on the information about Adam provided by EQ. However, if the lender delays until all of Adam's information has been verified, the lock when issued will be at the prices prevailing at the time it was requested.
EQ maintains a price archive for this purpose. The borrower is thus protected against the common practice of delaying the lock until market prices change, then locking at the requested prices if the current market price is lower, and at the current price if it is higher.
But EQ costs a lot to develop. It must provide qualified borrowers to participating lenders, which is a costly but essential step in transforming the information advantage of borrowers into an information advantage for borrowers. It must also develop systems for maintaining the underwriting requirements and pricing of every participating lender.
I thought we were on our way to EQ a decade ago. In 1997-98, five multi-lender shopping sites were formed, two of which were from major firms from outside the mortgage industry: Intuit ("Quicken Mortgage") and Microsoft ("HomeAdvisor"). GHR Systems Inc., the technology company with which I was affiliated, developed the systems for Quicken Mortgage and also worked on HomeAdvisor.
All of the sites were geared to protecting borrowers against transactional mistakes, but not lifestyle mistakes. They all failed, largely because of bad timing. They succeeded in attracting a great deal of traffic, but converted very few visits into loans.
Consumers had grown comfortable using the Web as a source of information, but were not yet comfortable transacting online. Borrowers went to the sites as a great source of current market data, then used the information in shopping traditional sources.
The heavy losses suffered on these ventures put a temporary damper on further investment in multi-lender shopping sites, which are costly to develop. Attention shifted to lead-generation sites, of which the best known are LendingTree and LowerMyBills.
These sites are relatively inexpensive to develop because they do not include any online shopping capacity. The consumer fills out a questionnaire on the site, which is distributed to as many as four lenders who then contact the consumer to pitch their wares.
One of them claims that "when banks compete, you win." The problem is that when banks compete but are free to lowball their prices, exaggerate their claims, and ignore potential risks and future costs, borrowers seldom win. And the process does not protect borrowers against lifestyle mistakes.
Four multi-lender shopping sites were started in 2007-08: Loan.com, Zillow Mortgage, Mortgage Marvel and Loan Grader. Each is reviewed in detail on my Web site. None of them protects borrowers adequately against transactional mistakes, in my opinion, and they provide little or no protection against lifestyle mistakes.
Full disclosure: There is a new kid on the block that has committed to a new approach, and I have agreed to work with this newcomer in an effort to better protect borrowers against transactional and lifestyle mistakes. Stay tuned.
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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