Rash decisions hurting borrowers

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

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