Consumer Mistakes in the Mortgage Market: Choosing Unwisely versus Not Switching Wisely

Abstract

Regulatory proposals for protecting consumers in the mortgage markets typically focus on making sure dangerous products are eliminated and consumers make informed product-choice decisions. These are intended to address consumers’ product-choice mistakes. But there is another class of mistakes that has received relatively little attention in the current regulatory debate: consumers’ failure to switch out of their mortgage products by refinancing in a timely manner. Studies have shown that once consumers choose mortgage products, they are slow to take advantage of reduced interest rates by refinancing efficiently. This is potentially worth several thousand dollars in interest cost savings. Safety or disclosure regulation can do very little to entice borrowers who are not constantly looking to maximize welfare. This Article makes three contributions: first, we rationalize failure-to-switch mistakes, using a neoclassical model of product search and market obfuscation; second, we explain why the market is unlikely to correct failure-to-switch mistakes on its own, based on the lessons we have learned about product-choice mistakes; third, we propose a simple solution that could potentially be effective in addressing sluggish refinancing. Our threshold suggestion is that the Consumer Financial Protection Bureau should establish, certify, and popularize a simple concept or methodology — much like APR — which conveys the net wealth and risk effects of refinancing to a given product. By creating a common language for consumers, lenders, and brokers, this approach can reduce consumers’ information costs, teach them to demand information in a useful format, combat market obfuscation, and importantly, encourage several market-based solutions in turn.

Keywords: Consumer credit, household behavior, regulation, mortgage, APR, consumer financial product, behavioral economics

JEL Classification: D1, D11, D18, G28