Mistakes That Mortgage Borrowers Make: Causes and Cures
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?
Transactional Decisions and Lifestyle Decisions
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.
Lifestyle decisions include how much to spend on a house, whether or not to refinance, what type of mortgage to take, how large a down payment 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 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%, and finds a loan at a competitive price. But at closing, Jones discovers that the broker is also being paid 1% 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 “low-balling”, 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.
Here is a typical lifestyle mistake. Smith has a 6% loan with a $200,000 balance and 10 years to go. She is offered a 5.75% refinance that will reduce her monthly payment from $2220 to $1267, 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 5 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.
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.
Existing Methods of Reducing Mistakes
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%, which is less than the rate on Smith’s 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 advisors 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 on-line 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.
The EQ Approach to Avoiding Transactional and Lifestyle Mistakes
I now want to 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 Adam logging onto EQ 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, which assumes one-size fits all. I discuss the need for this kind of measure, which I call Total Horizon Cost or THC, in How Do You Know Which Prices Are Lower? 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 Provides Pre-Application Counseling
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 down payment, 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.
Precursors of EQ
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 lenders 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, 5 multi-lender shopping sites were formed, two of which were from major firms from outside the mortgage industry: Intuit (“Quicken Mortgage”), and Microsoft (“Home Advisor.”). GHR Systems, Inc, the technology company with which I was affiliated, developed the systems for Quicken Mortgage and also worked on Home Advisor.
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 on-line. 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 Lending Tree and Lower My Bills. These sites are relatively inexpensive to develop because they do not include any on-line 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 low-ball 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 2007-8: Loan.com, ZillowMortgage.com, MortgageMarvel.com, and MortgageGrader.com. None of them protect borrowers adequately against transactional mistakes, and they provide little or no protection against lifestyle mistakes.
The good news is that there is a new kid on the block that is committed to doing it right, and I have agreed to work with them to make sure it happens. Stay tuned.
January 9, 2012 Postscript
The new kid on the block ended up creating another lead generation machine and I decided to create the EQ system myself. I scrapped that name, it is the Certified Lender Network (CLN), and it pretty much follows the description of EQ that I wrote in 2009. For a description, see Finding a Mortgage on the Professor's Certified Lender Network.