A few weeks ago, I put up a post on the neuroscience of subprime mortgages. A significant percentage of subprime loans get customers by advertising low introductory teaser rates, which trick the brain into making an irrational decision. In essence, we are duped into using our short-sighted emotional mind to make a long-term financial decision.
Look, for example, at the popular 2/28 loan, which consists of a low, fixed-interest rate for the first two years and a much higher, adjustable rate for the next twenty-eight. Most people taking out a 2/28 loan can’t afford the higher interest rates that will hit later on. It’s not unusual for interest payments on a 2/28 loan to double within four years. (That’s why you’re seeing such high foreclosure rates in the sub-prime market.)
David Laibson, a Harvard economist/neuroeconomist who specializes in hyperbolic discounting, has recently proposed a very simple way to rid the market of such teaser mortgages:
To prevent lending institutions from offering misleading deals that trap borrowers, we should require that all future mortgage loans be prepayable with no penalty. This is an easy, simple rule. The rule will have the effect of leading banks to stop offering many of the teaser rates that serve as loss leaders (pay too little interest for the first 18 months but then pay extra on the back end). These loss leaders are often confusing and tempting for borrowers. Banks won’t want to offer loss leaders if borrowers can get out of the loan without paying a penalty after the subsidized payment period — the teaser period — ends.
My proposal would not discourage banks from offering sensible adjustable rate mortgages (those without a loss leader component). Borrowers should be allowed to take out a mortgage pegged to short-term rates. That’s not a loss leader and such mortgages will still be offered if prepayment is made penalty-free. My proposal will only hit the mortgages with early loss leaders built into the payment stream.
That’s on Justin Fox’s blog. Check it out.