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The David Laibson plan for ending mortgage teaser-rate insanity - The Curious Capitalist - Justin Fox - Economy - Markets - Business - TIME: 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.

Don't you have to eliminate "points" as well? A lot of points plus a concessional interest rate amount to a prepayment penalty...

Comments

[Frank Bowden]

While awaiting comments from those more knowledgeable than I, I will suggest that the answer is "no." I don't think points amount to a prepayment penalty. It may or may not be a wise decision for people to pay points. The obvious benefit of this excellent suggestion is that it gives people the benefit of being able to escape a mortgage contract without penalty when it is no longer to their advantage. This provision may not prevent people from making mistakes, but remember, Brad, that the perfect is the enemy of the good.

[Frank Bowden]

While awaiting comments from those more knowledgeable than I, I will suggest that the answer is "no." I don't think points amount to a prepayment penalty. It may or may not be a wise decision for people to pay points. The obvious benefit of this excellent suggestion is that it gives people the benefit of being able to escape a mortgage contract without penalty when it is no longer to their advantage. This provision may not prevent people from making mistakes, but remember, Brad, that the perfect is the enemy of the good.

[matt wilbert]

I like this idea because it doesn't mess with the mortgage market too much, and I don't think that allowing points is a big problem, because the main problem with teaser interest rates is that they attract borrowers who don't have enough money to afford the loan after the concessional rate ends. But those borrowers probably don't have the money to pay the points, or at least would have trouble doing it, since it would have to be a lot of points to make up for a significantly reduced interest rate.

From a sales point of view, it would also probably be very hard to convince borrowers to cough the points up. It brings the cost forward in a very visible way, as opposed to an adjustment in a hazy future.

[bigTom]

I wouldn't be entirely against points, but I would propose that they be capped at a fairly modest level (say one or two points). This still doesn't address the issue of teaser payment schedules, i.e. a load that starts off with an initial low monthly payment (which without a teaser interest rate) is simply negative amortization for an initial period. My impression is that vulnerable people probably don't notice the interest rate, but are profoundly sensitive to the percieved near term monthly payments. Even though the loan originator can't make a windfall off the prepayment penalty, he may still have incentive to push such products onto the unwary.

[John Drake]

A mortgage with no prepayment penalty is like a callable bond. The value of the embedded call option should be no greater than the cost of the points. It seems to me that you pay one way or another.

[Bill Gardner]

Good question. Under hyperbolic discounting, you would over-estimate the cost of points and underestimate the cost of a prepayment penalty. Meaning that there would be people who would do better with a mortgage who would continue renting to avoid paying the points.

[supersaurus]

in loans I've gotten points were a tradeoff for lower interest, i.e. pay points up front and in return get a lower long-term rate (note these were all fixed rate mortgages), and the points cash was deductible the same as interest. I never figured out how to pencil the tradeoff exactly (partly because the present value of the tax effect was hard to predict), but it seems to me basically points were a bet between me and the bank, with the bank betting that I wouldn't stay in the house long enough to make up the interest I paid up front with savings from the lower rate. the bank never pressured me one way or the other, so I always thought they had enough data to set the points price so it was a wash for them on the average.

in other words on those loans points were only a prepayment penalty if I sold or refinanced too soon. I suppose you could deal with that by requiring the bank to specify the breakeven point ignoring the effect of the interest deduction, e.g. "if you hold this loan for 65 payments then you will break even by paying 2 points; the effects of any possible tax deduction caused by paying the points or any possible income derived from not paying them are not included in this calculation". of course the simplest thing would be to forbid points entirely.

[Dave]

I'm pretty sure here in Illinois you aren't allowed to charge prepayment penalties on any primary mortgages. Hasn't had any impact on these teaser rates.

[otey]

There are a number of states that do not permit prepayment penalties on consumer mortgages. The Harvard guys's theory has been tested and it seems to have little effect on the market.

Closing costs (points, appraisals, attorney fees, title insurance and all) are (and always have been) the biggest disincentives to refinancing.

[save_the_rustbelt]

I don't think the government should be writing mortgages, but a requirement for a clear, plain Enlgish disclosure of what the hell the mortgage really says would be helpful.

And people who do real estate deals without legal counsel are asking for trouble. If you are buying a $200,000 house spending $800 on a lawyer is a really good diea.

[Joel]

Points front-load the loan's yield curve, raising the actual (APY) rate paid short-term.

[Matt]

I can't wait to read all the comens on this.

Here is another idea. Time shift interest payments forward for lower credit borrowers. That is, they lock in an interest rate for three moths down the road by starting payments today. The loans are otherwise assumable.

The loan, therefore, as higher value if it is assumed by a higher credit borrower, due to the interest prepayment. There is a shared risk on the future interest rate.

A very good credit borrower sould get the payments shifted backward relative to loan origination.

THis makes loan negotiations a complex valued process, completing the loan side of the yield curve.

[Tom O]

30 years in the mortgage business here (and I haven't done subprime since 1982, so don't flame me for this screwup).

I guess it all depends on your objective. If your goal is to protect a relatively small number of necessitous or financially unsophisticated borrowers from predatory lenders, killing prepays for owner occupied loans would have a marginally beneficial result. If your goal is to stabilize the mortgage industry by eliminating risky loans, prepays are more or less irrelevant.

Prepays are not an issue in "A" quality first mortgages. FNMA and FHLMC don't charge prepays, and won't enforce it if they happen to buy a note that contains one. Since this covers the vast majority of "A" quality loans under $400,000, prepays are very rare on "A" quality mortgages.

"A" quality lenders, until recently at least, were able to hedge the risk of early payoff of low to no point loans, so didn't really need to charge a prepayment penalty to make the numbers work except in the most extreme, relatively rare programs.

You have to remember that most of these "A" quality teaser rates lasted three to five years, and were done when the lender's own cost of funds for the same term was in the 3% range. Since short term rates are now much higher, the issue of low "teaser" rates has solved itself, since lenders can no longer afford to offer them without charging more points than most borrowers will pay.

The problem is in subprime, where more needy and less sophisticated borrowers are taking a higher rate AND higher points AND a prepayment penalty, because they lack the knowledge and/or the FICO scores to do anything better. Since most subprime borrowers are highly motivated to borrow, the absence of a prepayment penalty just means they will be charged an additional point or two, but the loans will still be made.

Higher underwriting standards, in particular the elimination of 100% CLTV financing, and low down payment "Liar Loans" is the real solution to a more stable financing market.

Tom O

[bullb]

That covers only one part- it leaves out neg-am loans & ridiculous (C)LTVs

What exactly prevents the lender from adding the prepayment penalty into the loan amount and amortizing it ? In effect a negative option ARM? Nothing is going to break until the borrower tries to refinance before the payment shock hits, and then find he can't get one for the higher balance.

[Dean Baker]

Sounds like a good plan to me. I don't think we have to worry about points. Points are the opposite of teaser rates. If banks charge high points, then it makes the loan look like a bad deal to those not thinking about the future.