Put mortgage to 'time horizon cost' test
Editor's note: This is Part 4 of a five-part series.
Previous articles in this series focused on how certified lender networks will generate competitive pricing of both mortgage loans and the third-party services that are required accessories of mortgage loans. The focus of this article is the critical role of the networks in providing decision support, which is one of the weakest parts of the existing system.
Decisions borrowers must make
Decision support means helping borrowers make a series of complex decisions. These include the type of mortgage, in which borrowers must choose between the stability of a fixed-rate loan and the lower rate but greater risk on an adjustable-rate loan. They also must decide how much to put down, whether to pay points to reduce the rate, and, if mortgage insurance is required, the best type of premium plan.
On refinances, there is the overriding issue of whether the refinance will save them money or reduce their risk.
Rational decisions are borrower-specific
The best decision in any given case depends on factors unique to the borrower, including how long they expect to have the mortgage, how much they could earn on the monies they spend on the mortgage if it was invested ("opportunity cost"), and their marginal tax bracket. The last is relevant because interest payments and points are deductible, as are mortgage insurance premiums for some borrowers. Generic decision support not geared to the characteristics of the individual borrower is of limited use.
The existing system does not offer much useful help
Most borrowers are ill-equipped to make these decisions on their own. They know little about mortgages and few have any desire to learn for the sake of learning. Most just want to get through the process with the best possible deal. Unlike other transactions, there is little opportunity to learn from trial and error because transactions are too large and too infrequent.
The housing finance system as it is now constituted offers little help. Most of the loan officers and mortgage brokers with whom borrowers deal do not view borrower education as their responsibility, and are not trained for that purpose. Their primary focus is on getting deals done that borrowers will accept, and whether they are the right deals is incidental.
Internet-based calculators are a potential source of help but have serious limitations. I have 46 calculators on my website and despite my best efforts, borrowers have great trouble finding the one calculator that meets their need. The major problem is that the calculators are stand-alone -- they don't come up in context -- when they are needed to answer a question that arises in the loan origination process.
In addition, stand-alone calculators require that the user enter mortgage prices, which in most cases is guesswork and a potential source of error.
Government doesn't help
The government tries to help but fails. The centerpiece of its effort is a measure called the annual percentage rate, or APR, which lenders are required to disclose whenever they display an interest rate. It is a single number that is designed to measure the all-in cost of the mortgage to the borrower, except that it doesn't.
Most third-party charges are not included in the APR. Borrowers ignore the APR because they don't understand it, which is a good thing because it is a highly defective measure. Among other things, it ignores opportunity costs and taxes, assumes that every borrower holds the mortgage for the full term, and does not consider the risk of higher future interest rates on ARMs.
Decision support on the networks
Decision support will be a major function of the certified lender network. Borrowers will receive an offer of decision support in context, when the issue arises in the origination process. The calculator routines will use borrower-specific information, including the prices for which the borrower qualifies.
The cost measure used will be some variant of what I call "time horizon cost," or THC. The THC is the total cost of the mortgage in dollars over the period the borrower expects to be in the house. It makes more intuitive sense to borrowers than the APR and is easier to understand. It is comprehensive in its coverage.
And it takes account of differences between borrowers in time horizon, tax rates and opportunity costs. It can also be measured on ARMs using alternative assumptions about future interest rates, including "worst case," which gives borrowers a sense of whether they can tolerate the risk.
The THC can also be broken down into its components for borrowers seeking a deeper understanding of the bottom-line results. This enhances its credibility and encourages its use. The APR, in contrast, cannot be decomposed into understandable components, which is another reason it is not used.Â
Decision supports are for borrowers who need them and have the capacity to use them, which does not cover all network users. The network should also accommodate borrowers who don't need support because they already know exactly what they want, and at the other extreme, borrowers who need help but can't manage online supports on their own. This suggests a need for multiple channels, which is the topic of next week's article.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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