"Are consumers making better decisions about the kinds of mortgages they select than they did before the financial crisis?"
The mortgages being written today are certainly better matched to the needs and payment capacity of borrowers than they were before the crisis. The major reason, however, is not better decision-making by consumers but elimination of the toxic mortgages that led so many consumers astray. The option ARM, which allowed borrowers to make payments in the early years that did not cover the interest while exposing them to the risk of sizeable payment increases in the future, are no longer being offered. It’s somewhat less-dangerous cousin, the interest-only mortgage, is still around but priced so high that few borrowers select it.
Another reason the quality of mortgage decisions has improved is that the sub-prime and alt-A markets, which had channeled loans to consumers with the weakest qualifications for home ownership, are both gone. The average mortgage borrower today is much better qualified than before the crisis because the less-qualified borrowers are not being approved.
However, better decisions resulting from a curtailment of options and tighter eligibility requirements are not an unsullied blessing. The option ARM had some legitimate uses, and these have been lost along with the abuses. Worse, more stringent qualification requirements have over-shot the mark and some very well-qualified consumers, including large numbers of the self-employed, are unable to borrow.
Given the available options, consumer decision-making today is no better than it was because the factors that lead to bad decisions have not changed.
Borrower Ignorance
Mortgages tend to be complicated, and consumers are exposed to them only once or a few times during a lifetime. They have no opportunity to enhance their knowledge through trial and error, which is largely how they learn about other products. While some potential mortgage borrowers, recognizing the importance of the decision, will put in the time required to become knowledgeable, most prefer to depend largely on the advice of others.
Poor Advice
In selecting a mortgage, most borrowers get their advice from their loan provider (LP) — a loan officer or mortgage broker. In the worst case, which was fairly common before the financial crisis, some LPs steered borrowers to the products on which the LP made a larger commission. Under regulations issued this year, such steering is against the law.
Eliminating biased advice does not generate good advice, however. Most LPs remain transaction-oriented, meaning that they are looking to get the deal done rather than to establish a relationship with the client. They earn no more if the borrower selects the right type of mortgage than if they select the wrong type. What matters is that the borrower is satisfied with the LP’s advice and the loan closes.
The advice given by LPs is only as good as their capacity to provide it, and while there are some good ones, they are the exception. LPs are not selected for their pedagogical skills, they are not trained for it, and they are not rewarded for it.
Poor Disclosures
One of the alleged purposes of mandatory disclosures is to help borrowers compare different types of mortgages. The cornerstone of such efforts is the annual percentage rate or APR, which is supposed to be an objective measure of mortgage cost that allows borrowers to make unbiased comparisons. The trouble is that it does this only in a very restrictive set of circumstances, which regulators have never spelled out.
Because the APR is calculated over the full term of a mortgage, it is misleading if used in selecting the mortgage type by borrowers who expect that they will sell their house or refinance the mortgage within a relatively short period. For the same reason, it leads borrowers astray who are comparing different combinations of interest rate and points on a given type of mortgage.
Perhaps it is fortunate that because most borrowers don’t understand the APR, few try to use it.
In next week’s article, I suggest that many borrowers in today’s market are making a mistake in selecting a fixed-rate mortgage over an adjustable rate mortgage (ARM).
Jack M. Guttentag, now Professor of Finance Emeritus, formerly Jacob Safra Professor of International Banking, at the Wharton School of the University of Pennsylvania. Earlier he was Chief of the Domestic Research Division of the Federal Reserve Bank of New York, on the senior staff of the National Bureau of Economic Research, and managing editor of both the Journal of Finance (1974-77) and the Housing Finance Review (1983-89).
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