The Worst Mistake of Mortgage Borrowers

February 19, 2001, Revised January 19, 2011, January 3, 2012 Postscript

“What’s the worst mistake mortgage borrowers make?”

The worst mistake by far is making decisions based solely on the affordability of monthly payments, without considering how the decisions will affect the equity in their homes. I call this malady “payment myopia”.

Homeowner equity is the value of the home less total mortgage debt. It is the largest part of the total wealth of many households, and during retirement years serves as a cushion against financial hardship. If you neglect homeowner equity when you make financial decisions, you neglect your financial future.

Payment myopia is not one specific mistake but a general approach to financial decisions that can lead to a lifetime of mistakes. It arises out of a lifestyle focus on the present, and an unwillingness to defer gratification. Those afflicted want what they want now.

Consumers who are payment myopic all their lives seldom retire with significant wealth. The financial system offers them numerous opportunities for short-term gratification at the expense of the future. The examples below apply to mortgages, but similar stories could be told about credit cards, automobile loans and other types of credit.

Debt Consolidation

Home owners with substantial short-term debt usually can consolidate the debt into their first or second mortgage. The interest rate on the consolidation mortgage is typically lower than the rates on the short-term debt, and the mortgage interest payments are tax-deductible. Because of the lower interest rate and the tax savings, total monthly payments are reduced. Read Pros and Cons of Debt Consolidation.

Payment myopic consumers, however, view the reduced payments as an invitation to assume more short-term debt, which can lead to further consolidations. Each consolidation reduces homeowner equity, and raises the interest rate on the next consolidation. At higher interest rates, a larger portion of monthly mortgage payments goes to interest, leaving less for reduction of principal.

Long Terms

Payment myopic consumers also select the longest term available because it results in the lowest payment. This is usually a 30-year mortgage. Increasingly it is a 30-year mortgage that is interest-only for up to 10 years.

The longer the term, the slower the growth in homeowner equity. The higher rate on longer-term mortgages, furthermore, causes a loss in homeowner equity growth that is larger than the savings from the lower monthly payment.

For example, compare a $100,000 loan at 8% for 30 years with the same loan at 7.625% for 15 years. Over the first 5 years, a borrower selecting the 30 would save $12,202 in payments compared to the borrower selecting the 15. But the loan balance on the 30 would be $16,805 higher than the balance on the 15 at the end of the period.

Low (or No) Down Payment

Payment myopic consumers usually are unable to save a down payment. Anywhere else in the world, they would be permanent renters. But in the US, they can get home mortgages without a down payment, provided they have decent credit. At least, that was the case before the financial crisis. In 2011, you needed to put 3% down to qualify (on an FHA).

Consumers who can’t save for a down payment prior to purchasing a house pay higher interest rates than consumers who make down payments, or they pay mortgage insurance premiums. This means that their equity will grow less rapidly in the future.

Sub-Prime Loans

Payment-myopic consumers also tend to live closer to the edge, and are more likely to pay late and default more frequently than equity growth-minded consumers. Nevertheless, before the financial crisis, consumers with spotty credit records could often borrow in the sub-prime market. As with borrowers who put nothing down, they paid a high price for their loans, which slowed down the future growth of their equity. While the sub-prime market disappeared with the financial crisis, by 2011 there were signs of a reemergence.

Financial markets in the US offer consumers a wider range of options for incurring debt than any other country. The options discussed above, and many others have legitimate uses. They provide valuable opportunities to consumers who are forced by circumstances to be payment myopic, but later grow out of it as their financial circumstances improve.

Unfortunately, other consumers never outgrow their payment myopia. If they didn’t have access to these options, they might accumulate more wealth over their lifetimes. But that’s their problem. It is bad policy to eliminate options that help many consumers because some others abuse them.

January 3, 2012 Postscript

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