Avoiding costly mortgage mistakes

Flickr image by oddsock.

Shortly after starting my Web site, I decided to add a feature on some of the common mistakes borrowers make, and how to avoid them. Today, there are about 100 mistakes on the list, and it continues to grow.

Recently, I decided to take another look at this list as I pondered a different question: Why do mortgage borrowers make so many mistakes, and are there changes in the system that would reduce them?

I found that virtually all of the mistakes that borrowers make fall into two broad categories: transactional decisions and lifestyle decisions. The first category includes such decisions as where to go to obtain market information, how to find a mortgage provider, how to shop alternative providers, how to make price comparisons, and the like.

The goal underlying these decisions is to obtain a loan at the best terms available in the current market. The mistakes that borrowers make result in their paying too much for the mortgage.

Here is a typical transactional mistake: Jones retains a mortgage broker for the $200,000 loan he needs to buy a house; the broker charges him a fee of 1 percent and finds a loan at a competitive price.

But at closing, Jones discovers that the broker is also being paid 1 percent by the lender, and that without the lender's payment his rate would have been a little lower. Jones' mistake cost him a higher rate that has a present value of about $2,000.

Borrowers make transactional mistakes mainly because of "information asymmetry," which is the term economists use to describe a market in which one party knows much less than the other. Mortgage borrowers know much less than loan providers and are therefore disadvantaged in negotiating prices.

Loan providers, whose incomes are largely based on doing deals, have numerous techniques designed to exploit their information advantage.

Two common ones are "lowballing," which is the practice of quoting prices below those the loan provider can deliver, in order to hook the customer; and "fee escalation," which is the practice of raising loan fees after the borrower is committed, as the loan moves toward closing.

I have discussed these and other techniques in previous articles and on my Web site.

Lifestyle decisions include how much to spend on a house, whether or not to refinance, what type of mortgage to take, how large a downpayment to make, and whether to pay points. The goal underlying these decisions is (or should be) to be as wealthy as possible when the house is sold, or beyond. Mistakes on lifestyle decisions are often much more costly to the borrower than mistakes on transactional decisions. The costs can run for many years, in some cases even a lifetime.

Here is a typical lifestyle mistake: Smith has a 6 percent loan with a $200,000 balance and 10 years to go. She is offered a 5.75 percent refinance that will reduce her monthly payment from $2,220 to $1,267, with no cash out of pocket required. Smith found this an irresistible deal, as would many others.

However, upfront charges on this loan amounting to $17,000 were financed, that is, included in the loan amount. At the end of five years, Smith would be about $24,000 poorer than if she had stayed with her original loan. The present value cost of Smith's mistake was about $18,000. ...CONTINUED

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