The Optimal Mortgage For The Rational Borrower

Two professors have released a paper branding adjustable rate mortgages, which are responsible for the subprime meltdown, as the optimal mortgage type for rational borrowers. As we know all too well, few borrowers are antiseptically rational. According to Columbia professor Tomasz Piskorski and NYU professor Alexei Tchistyi, ARMs hold several unrivaled advantages:

•The option to pay less than the minimum monthly interest owed on the loan is valuable for people with good self-control whose income fluctuates a lot. They can pay just a little in lean months and catch up in fat months. It’s good for lenders, too, because they don’t have to foreclose on people who fall behind, which is an expensive process. People with steady incomes don’t need this feature, but having it doesn’t hurt them.

•The fact that the loan is an ARM–namely, its rate fluctuates with market interest rates–is especially valuable to lenders. This is a subtler notion, but the idea is that if there are going to be a certain number of defaults in a pool of mortgages because of random bits of bad luck like a job loss or a divorce, the lender would prefer that they be concentrated during periods of high interest rates. Why? Because when market interest rates are high, the lender that forecloses and gets back (most of) its money can redeploy the cash in high-yielding alternatives. The lender would prefer not to foreclose and get its money back when rates are low and other options are unattractive. An ARM loan achieves what the lender wants. Borrowers, meanwhile, are neutral about whether they default in periods of high or low market interest rates.

•Finally, the economists say the optimal loan contract would outright ban getting a new loan from a different lender. There are no such bans. But they say that the prepayment penalties that are common in subprime loans are a good second best. How could that be? Because lenders will offer more favorable terms if they know that they’ll be able to hang onto the loan long enough for it to be profitable. If they fear that the borrower will refinance at the drop of a hat, they’ll give less favorable terms.

The difference between conventional mortgages and ARMs can be worth half a percentage point of interest, or $50 billion in savings for the nation as a whole – but only if everyone acts rationally.

BusinessWeek cutely suggests that if the research is right:

…maybe it makes sense to get people to behave rationally through extensive, even expensive, consumer education.

Surprise: ‘Toxic’ Mortgages Are the Best [BusinessWeek]
(AP Photo/Denis Poroy)


Edit Your Comment

  1. Crazytree says:

    full-doc loans not fool-doc loans!

  2. nweaver says:

    Except for one BIG problem:

    Because there isn’t a lock-out on refinancing (which would be “good” for the lender but not good for the borrower, prepayment fees are bad enough), a 30 year fixed is really a “ratchett down” ARM: you can refinance to a lower price should interest rates fall, but you are hedged against a rise.

    This is especially true with long term rates at a remarkably low ~6%.

  3. humphrmi says:

    They’ve mis-named this “report.”

    These are the optimal loans for lenders. They even admit it in Paragraph 2:

    The fact that the loan is an ARM–namely, its rate fluctuates with market interest rates–is especially valuable to lenders

    This reads to me: “Help! I’m a subprime borrower who has lost all of my business lately! Help me out, by buying stupid mortgages again! If you don’t buy stupid mortgages, I go broke!”

  4. humphrmi says:

    Whoops, my last paragraph should have read “Help! I’m a subprime lender who has lost all my business…”

    Anyway, go suck eggs. The party’s over, now it’s back to the (sane) mantra: Fixed, Fixed, Fixed!

  5. kenblakely says:

    I live in the UK right now – I’m writing this from my house in Dorset. The kicker in the UK is that DSL is considered ‘broadband’, and it’s usually capped at 128kb/s, ie, not a whole lot better than dial-up. Secondly, the broadband access rates (just like everything else in the UK) are outrageously expensive. So, if you’re anywhere outside of a major metropolitan area (London, Manchester, Liverpool, etc), you’re screwed for genuine high-speed access. I know it’s fashionable to think that anything in Europe must be cooler-better-cheaper-etc, but it’s not. The only upside is that the ISPs will fight for your business – offering discounts and incentives, especially at the end of your contract. It’s like the long-distance wars in the early 90’s in the US, and that *is* nice….

  6. edrebber says:

    You’d be penalized if you came into alot of money and wanted pay off your mortgage.

  7. Nytmare says:

    I thought ARMs come with an initial low fixed rate, to draw your focus away from the standard high payments. And high payments in the long term does not seem like a rational choice to me.

  8. DJ-Pandemic says:

    The only Sane loan is to get a 10 or 15 year fixed. The payments on at 15 are not much more than a 30, and you save gobs of money over the life of the loan.

  9. Charles Duffy says:

    @humphrmi: Optimal for the consumer as well: Giving the lender a benefit which doesn’t harm the consumer significantly (because the rational consumer is paying much more than their minimum payment on these loans anyhow, so what does it matter if their minimum goes up a bit?) means that the lender can offer the consumer better terms elsewhere.

  10. Charles Duffy says:

    @DJ-Pandemic: …or you get a 30, and pay it off at the rate of a 10 or 15 (but with the flexibility to make lower payments temporarily if necessary).

  11. GearheadGeek says:

    There are ARMS and then there are ARMS. When I bought my first house in 1994, 30-yr fixed rates were over 8%. I got an ARM significantly lower than that, with a rate lock for 3 years (if I recall correctly) and it could adjust a maximum of 1% per year once per year thereafter. Once it started adjusting, it fell every year for a while and I refinanced to a fixed rate in a rate trough several years later. It was a fully-amortized loan, I was always paying some principal with each payment. It was quite a rational decision.

    That said, you don’t buy an ARM with rates at historic lows, that’s never rational. Not even the air-quotes “rational” that economists use.

  12. CumaeanSibyl says:

    @Charles Duffy: Best answer — gives you the most control over your extra money.

  13. BrockBrockman says:

    Doesn’t this study not only require “rational borrowers,” but also “rational lenders”? The study presupposes that lenders will not abuse “lock-outs” and will provide extra incentives to borrowers resulting from their guaranteed extra profits.

    The entire query fails to address the biggest issue: borrowers who obtain loans, and lenders who gives loans, for more money than a borrower can afford, regardless of interest rates.