Should teaser mortgage rates be illegal? (A hyberbolically discounted examination)

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I keep getting offers in the mail from an outfit called Allied Mortgage that says it can cut my mortgage payments in half by refinancing at 6.125%. I don’t see how that’s possible, given that my current rate (on a 7/1 ARM) is less than that. I saw a similar offer in an ad online the other day (I think it was from Lending Tree, but am not absolutely certain), clicked through and learned that the low payments were the product of a one-year teaser rate on an interest-only mortgage.

My first thought is that it’s remarkable that lenders are still trying to pull this kind of nonsense. My second is that maybe it ought to be illegal, because teaser rates and interest-only loans are so obviously structured to exploit a quirk in how the human mind works.

A rational economic man assesses future financial costs and benefits by applying a constant discount rate. If it’s 5%, say, $100 twenty years from now is worth $38 today, $100 five years from now is worth $78 today, etc. (The formula for figuring this out can be found here.)

In real life, though, most of us do not apply a constant discount rate. We apply one rate for the present and near future, and a much-lower rate to the more distant future. If you plot the curve of these changing discount rates over time, you get something that looks like a hyperbola, hence that extremely catchy phrase “hyperbolic discounting.”

It’s not just humans who do this. The initial research on hyperbolic discounting was done on pigeons, by psychiatrist George Ainslie. Hersh Shefrin and Dick Thaler introduced it to economics in 1981. It didn’t catch on back then, but in the past decade or so, thanks in large part to the work of Harvard’s David Laibson, interest in the topic has taken off.

The practical lesson from this work is that we make better choices (that is, choices more in line with our medium- and long-term needs and desires) if present and future benefits or costs are bundled together. That is, if you have to decide anew every year how much to set aside for retirement, you’re likely to save a lot less than if you have to make a long-term commitment to saving that’s hard to back out of. This is the genesis of Thaler and Shlomo Benartzi’s semi-famous “Save More Tomorrow” plan to get workers to commit to funnel part of their future salary increases into their 401(k)s, and it’s having a big impact these days on the structuring of corporate retirement programs.

Teaser rates are an obvious example of the opposite approach, unbundling. That is, the sales pitch focuses only on the immediate cost, exiling the real cost over time to the fine print. It targets our more irresponsible selves.

Now I can’t really advocate banning the things. For one thing, where would you draw the line? I like to think my wife and I were making a totally rational bet about our future financial situation when we took out a 7/1 ARM (that is, an ARM with a seven-year fixed “teaser” rate) instead of a fixed-rate mortgage. My feeling is that most people with a one-year teaser rate aren’t doing the same, but I wouldn’t know how to back up that feeling empirically or theoretically.

I do think Truth in Lending laws ought to require that any ad or other sales pitch for a teaser-rate mortgage include in equally large print, on the same page, an estimate of what the monthly payment will go up to when the teaser period expires. I’m not so sure how to handle interest-only loans, other than maybe some big surgeon-general type warning about their risks. Anybody got any better ideas? (Non-hyperbolic ones, of course.)

Update: I’ve got another post on the topic, with David Laibson’s plan for stopping the teaser-rate madness, here.

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