June 18, 2012

Along with many other observers of the mortgage scene, I have long attributed the imperfections of the market in large part to information asymmetry – the fact that borrowers have access to less information than the loan originators they deal with. Borrowers enter the market once or a few times in their life whereas originators are in it every day.  

The obvious remedy for information asymmetry is to level the playing field by requiring lenders to provide borrowers with the information they need, and this is the intent of the Federal Truth in Lending and Real Estate Settlement Procedures Acts, along with many similar state laws. While these efforts have all failed, I always attributed the failures to regulatory ineptitude --  regulators have over-loaded borrowers with useless information while omitting what borrowers really needed. 

One of the benefits of offering mortgages on my web site is that I can provide borrowers with the information I think they should have, and then I can watch to see if they use it properly. Note that I don’t infringe on their privacy by doing this because they are anonymous when I observe them. 

I recently decided to check on how borrowers who qualified for both conventional and FHA mortgages were deciding between them. This can be challenging because their interest rates may differ, lender fees may differ, and mortgage insurance premiums will always be different. In balancing these off against one another, one should consider that interest rates are paid over the life of the loan, lender fees are paid up-front, and mortgage insurance premiums can be either or both. Usually, FHAs have lower interest rates but higher mortgage insurance premiums, while lender fees can go either way. 

I advise potential borrowers selecting a mortgage on my web site to choose the mortgage with the lowest total cost over the period they expect to have the mortgage, which is a figure we calculate for them. Total cost covers the rate, fees and insurance premiums and adjusts each for the time value of money. A proviso is that the borrower can afford the initial monthly payment and have the upfront cash required.  

Do they follow this advice?  I recently looked over the shoulder of a borrower who wanted a 30-year fixed-rate mortgage, and was offered a choice between conventional and FHA loans having the following features: 

30-Year FRM of $250,000 

The FHA has a lower rate and a lower monthly mortgage payment but the borrower has to pay a monthly mortgage insurance premium which makes the total monthly payment on the FHA significantly higher. Further, the total cost of the FHA over the 8 years the borrower expects to have the mortgage is substantially higher. The borrower should have selected the conventional. In fact, he selected the FHA.  

Why he made this mistake I don’t know but it was not because of a lack of information. He had all the relevant data, which included a complete breakdown of the components of total cost. My surmise is that he saw the large difference in the interest rate and at that point his mind disengaged. A further check revealed that other borrowers were making the same mistake. 

Is there any way to protect consumers who, despite the large amounts of money at stake, make decisions impulsively rather than thoughtfully? Displaying all the information available for a rational decision is clearly not enough. It also matters how the information is displayed. In the case at hand, we decided to change the tabular display shown above with the one shown below. 

30-Year FRM of $250,000 

 By including the mortgage insurance premium in the monthly payment, we force the impulsive shopper to confront the total monthly payment, which in the case at hand, is higher on the FHA. Hopefully, this will reduce bad impulse-based decisions, but we won’t know for sure until we check it out. 

Of course, we could eliminate bad impulse-based decisions by eliminating the option, and we carefully considered doing that. We didn’t because it smacks of arrogance, and I hate eliminating options. We decided first to exhaust all the possibilities for improving the way we present information.

Postscript: After this article was published, a number of real estate agents took me to task for failing to point out that FHA loans were available with down payments of 3.5% and conventional loans were not. This made me realize that I had been amiss in not making clearer that the theme of the article was that information presentation is as important as information availability. It was not about the relative merits of FHAs and conventionals.