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
Why do borrowers make lifestyle mistakes? Partly for the same reason they make transactional mistakes: namely, they are dealing with someone who knows more than they do and is motivated to get the deal done. A second reason is that lifestyle decisions can be complicated and difficult to analyze.
A third reason is that borrowers very often are payment myopic, giving undue weight to the payment because that is what they must pay now, and insufficient weight to the balance because that isn’t relevant until much later. All three of these factors were involved in Smith’s mistake.
How can the number of mistakes be reduced? Disclosures mandated by government have not been effective in preventing transactional mistakes, and they are even less effective in dealing with lifestyle mistakes. The centerpiece of Truth in Lending is the annual percentage rate (APR), which must be shown whenever the interest rate is shown.
But APR is a poor measure that may give the wrong answer as often as the right one. For example, the APR in Smith’s case was 5.91 percent, which is less than the rate on her existing mortgage and is therefore not very likely to dissuade her from making an $18,000 mistake.
I have tried to help borrowers avoid transactional mistakes by warning them against the various tricks of the mortgage banking trade, and by sending them to loan providers who are committed to transparency in their dealings with borrowers: Upfront Mortgage Brokers (UMBs) and Upfront Mortgage Lenders (UMLs).
However, a commitment to transparency does not make these loan providers reliable advisers on lifestyle issues.
I have tried to help borrowers avoid costly lifestyle mistakes by developing calculators designed to show all the consequences of the many types of lifestyle decisions borrowers make. I used one of them to assess Smith’s costly mistake.
But calculators have serious limitations. Many borrowers have difficulty finding the right calculator to deal with their particular problem. Furthermore, the calculators require that the borrower input information about the terms of the loan that is being considered, which the borrower does not know with any certainty.
Lenders could deal with these problems by integrating calculators into their online pricing and qualification systems, but none of them do it. Lenders don’t view providing this kind of service as a way to attract more customers.
Next week: A private-sector initiative that could reduce both transactional and lifestyle mistakes.
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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