How is it that, eight years after the financial crisis, there are 549,000 homes currently in some stage of foreclosure? A recent study found that 20 percent of American households should have refinanced in 2010, but did not. Potential loss: $45,000 over the lifetime of the loan. Another study found that 25 percent had interest rates more than two percent above the current market and that such costly mistakes especially affected those with less education or lower incomes.
According to Consumer Mistakes in the Mortgage Market, the US mortgage market is fundamentally flawed in ways that transfer wealth from unsophisticated homeowners to financial institutions and more sophisticated consumers, increase risk to the least well off, reduce the efficiency of the housing market and economy and produce greater inequality and social injustice.
It’s fundamentally about how less financially literate consumers, faced with poor information (“obfuscation”), lack of expertise and mistrust of the financial system can make poor choices when financing and refinancing a home. For example, less sophisticated consumers focus too much on short-term costs, at the expense of the long-run. Some banks and mortgage brokers may exploit this bias with hidden fees and teaser rates and by limiting information about refinancing opportunities so they can keep those above-market interest rate loans.
Less sophisticated borrowers may face higher search costs for the best deal because they may not know where to look or how to compare different offers, which can have subtle differences. For example, choosing between a 5/1 ARM, 10/1 ARM and a 30 year fixed rate mortgage requires understanding industry jargon and creating a scenario analysis of different personal and macro-economic scenarios. Many people may not even be aware of what the interest rate on their mortgage is. Many of the students in my graduate-level Cost Benefit Analysis class who fit the demographic, did not understand what an interest rate was. The result is they may not get the best deal or delay refinancing, missing out on savings.
…newly educated consumers are not profitable to any firm
The authors describe ways in which the mortgage market fails and argues for increased regulation to address these failures. In short, financial institutions benefit from the status quo and have little incentive to educate borrowers or compete on the basis of better disclosures or other decision-support measures. They argue that effective regulation would have several social benefits:
- Fairer distribution of wealth
- Fewer bankruptcies and foreclosures
- Avoided impacts on physical and mental health of financial distress
- More efficient economy
- More participation in financial (and housing) markets
The authors propose that the Consumer Financial Protection Board (CFPB) develop and impose on the industry a more robust measure of Annual Percentage Rate (APR) and standardized measures of the effects of refinancing on wealth and risk. While this proposal can’t hurt, the impact is likely to be marginal. People will still be faced by procrastination, inattention, present bias, ambiguity aversion, math anxiety, mistrust and financial-economic illiteracy.
An effective response has to include credible decision tools that incorporate all of the relevant facts and financial-economic and risk management concepts, as well as consumer objectives to help them make a wise decision when financing and re-financing their homes. These are complex financial products in a complex world: only simple yet sophisticated tools can level the playing field with institutions.
What’s your experience?