Mortgage Complexity and Choice Architecture
The complexity of modern mortgages, with numerous options and hidden fees, exploits behavioral biases like present bias and creates sludge that disadvantages unsophisticated borrowers. Choice architecture solutions such as simplified disclosure, standardized 'EZ mortgages', and smart disclosure with choice engines can help consumers make better decisions.
THE IDEA
The Problem
Thaler and Sunstein describe how mortgage shopping became more complicated. Fixed-rate mortgages with a 20% down payment made some comparisons straightforward: borrowers could compare APRs. The authors contrast this with an array of options: variable-rate loans, interest-only loans, teaser rates, points, prepayment penalties, and more. This complexity creates 'sludge' that makes it difficult for consumers to compare options and make informed decisions.
Evidence of Biases and Exploitation
Teaser rates exploit present bias by offering low initial rates that later increase dramatically. The authors describe conflicts of interest when brokers’ fees depend on loan profitability, rewarding them for selling expensive products. They link these practices to the 2008 financial crisis.
The book reports these findings from Susan Woodward's research:
- African American and Latino borrowers pay more after adjusting for risk.
- Borrowers in less-educated neighborhoods pay more.
- Shopping around (calling two more brokers) saves nearly $1,400 on average.
- Brokered loans are more expensive than direct loans.
Hidden fees can weaken price competition by making offers hard to compare. The authors contrast mortgage costs with the visible prices at gas stations.
Proposal 1: Disclosure
Require lenders to provide a single-page list of all major costs, added up and incorporated into the quoted interest rate to facilitate comparison.
Proposal 2: Standardization (EZ Mortgages)
Create a small set of standardized mortgage types (e.g., fixed-rate and variable-rate in 15- and 30-year terms) with identical fine print and no hidden fees. Borrowers can then simply choose the lowest APR within each category. Other, more complex mortgages remain available but come with warnings.
Proposal 3: Smart Disclosure and Choice Engines
Make all mortgage details available in a structured electronic format (the Mortgage File). Choice engines (like travel websites) can then help consumers find the best options. The authors argue that such engines would be easier to audit than human advisers and that online shopping could reduce disparities for women and minorities.
When to use it
Designing a standardized EZ mortgage category so borrowers can compare loans with the same terms and fine print.
Designing a mortgage comparison service around structured disclosures and the borrower’s criteria.
Evaluating financial products by requesting a single-page disclosure of all major costs.
Assessing the advice of a broker or agent by checking for potential conflicts of interest.
FROM THEORY TO EVERYDAY LIFE
In practice
Teaser rates exploit present bias
Lenders offer low initial interest rates that increase after a year or two, tempting borrowers who focus on the immediate low payments.
Mortgage broker conflicts of interest
Mortgage brokers are paid based on loan profitability, so they are incentivized to steer borrowers toward more expensive loans.
Gas stations vs. mortgage lenders
At gas stations, prices are visible and competition leads to price convergence, but mortgage costs are shrouded, so competition does not guarantee low prices.
Woodward's findings on inequality
In the research reported by the authors, African American and Latino borrowers paid more after adjustment for risk, and borrowers in less-educated neighborhoods also paid more. Calling two more brokers saved nearly $1,400 in fees on average.
A MOMENT TO REFLECT
Put it to work.
Reflect on a recent major financial decision you made. Were there any aspects that were shrouded or difficult to compare? How might you use the principles of smart disclosure to make better choices in the future?
Consider the role of advisors in your life (financial, medical, etc.). How can you guard against conflicts of interest when seeking advice?
The text proposes standardization as a solution. What are the potential downsides of standardizing products like mortgages? How can we balance simplification with flexibility?
Often confused with
CONTINUE THE CONVERSATION
Source texts
- Nudge The Final Edition (Richard H. Thaler Cass R. Sunstein)