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.
Transactional Mistakes
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.
Lifestyle Mistakes
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 Counselling
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 borrowers 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.