The David Laibson plan for ending mortgage teaser-rate insanity

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My post Tuesday on the evils of teaser-rate mortgages engendered a lot of comment. This probably had less to do with the actual content of the post than with the fact that it was linked to on the CNNMoney home page, but whatever. It’s a topic folks are interested in these days, for good reason.

Now Harvard economist David Laibson, whom I mentioned in the previous post as an expert on “hyperbolic discounting”–academicspeak for the human tendency to pay too little attention to costs and benefits in the distant (and sometimes not so distant) future–has come forward with a simple proposal to end teaser madness. Here it is, a Curious Capitalist World Exclusive:

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.

I like it. Simple and elegant.

Update: Brad DeLong was kind enough to reprint this post in his blog (with a great headline). The ensuing discussion in the comments there is worth reading, if you’re interested in this stuff.

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