The Paradox of Choice and the Mortgage Crisis

by Emily Guy Birken on 26 February 2013 2 comments

If you're interested in having an illuminating (if possibly boring) evening, ask your parents or grandparents to tell you about the details of buying their first house. After getting over your indignation at the fact that homes a mile from Washington D.C. could be had for less than $50,000 in the early '70s, you might be surprised to hear how easy the process of getting a mortgage was back in the day. (See also: Quiz: Am I Really Ready to Buy a Home?)

That's not to say that saving for the down payment, getting approved, and going through the mind numbing stack of paperwork at closing was any simpler or more fun when our parents were newlyweds — it's just that they had fewer options for their mortgages.

In fact, they basically only had one option — a 30-year fixed-rate mortgage for which they had to put down 20%. While they could shop around for the best annual percentage rates, that shopping around was fairly easy since they were only comparing APRs for the same kind of mortgage. Choosing the best mortgage was as simple as finding the lowest interest rate.

Fast forward to the new millennium. Anyone who bought a house during the housing bubble can remember the dizzying array of choices available for mortgages: traditional 30-year fixed-rate mortgages (as well as other fixed-rate mortgages with different term lengths), adjustable rate mortgages, sub-prime mortgages, interest-only mortgages (a misnomer if there ever was one), piggyback loans, mortgage buydowns — and those are just the options that I understand. Compared to our parents and grandparents, we were offered (and are still offered) a veritable wonderland of mortgage choices.

That ought to be a good thing, right?

You would think so. As Americans, we have a basic understanding that more choices mean more freedom — and boy do we love our freedom. But there's a reason why we had a mortgage crisis after all of these mortgage choices became available. It's part of what author Barry Schwartz describes as the Paradox of Choice in his book by the same name. Basically, having all this extra choice available does not make us any more likely to take the most rational and intelligent course of action — and according to Schwartz, extra choice actually has the opposite effect, making our choices less rational and less likely to make us happy.

While there's no denying that many different issues worked together to create the mortgage crisis, I would suggest that the paradox of choice at least played a part in why our housing market collapsed in 2007-2008. Here's why.

The Optimism Bias

Human beings are spectacularly bad at predicting the future. This doesn't just mean that we're lousy at picking stocks or the winning team for the Super Bowl — we're also horrible at figuring out what the heck we ourselves will want in the future.

If you've ever felt the Netflix dread that occurs after you receive the disc for the 17-hour award-winning documentary on beet farms in Romania when all you want to do is watch "Weekend at Bernie's," you know exactly what I mean. You may think when you choose it that you'll want to watch "Love and Death in the Beet Farms" by the time it comes up in your queue, but you're making some assumptions about your future self that simply aren't true. Namely, that you will someday be the type of person who watches thought-provoking beet-related cinema, when in fact you're always a slapstick comedy kind of guy.

An important aspect of our inability to predict what will make us happy in the future is a phenomenon called the optimism bias. We all experience this bias, even if it's just the false optimism about your ability to raise the tone of your movie preferences.

In most cases, however, the optimism bias works to make us blind to possible negative consequences. No matter how pessimistic an outlook you may have, you are more likely to think that bad things will not happen to you and that good things are in store for you, than is statistically likely. The optimism bias is the reason why smokers feel comfortable with their risk of cancer and lung disease ("It won't happen to me!") and why traders feel as though they can take big financial risks ("Losses can't touch me!").

In terms of the mortgage crisis, the optimism bias led many borrowers to take on more debt than they were able to handle. For instance, many of these innovative mortgage options allowed borrowers to increase the maximum amount they could borrow. While these new mortgages were designed to give borrowers more flexibility, that's not what happened. According to Dan Ariely, a behavioral economist at Duke University and author of Predictably Irrational,

When deciding on a mortgage, borrowers were told by the banks and by any mortgage calculator the maximum amount that they could borrow and not the optimal amount that they should borrow. So given a borrowing max of $400,000 with a regular mortgage or a borrowing max of $650,000 with an interest-only mortgage, would the average consumer borrow $400,000 with the interest-only mortgage and this way gain flexibility, or would they borrow to the new max? (Emphasis mine.)

It's fairly clear that the flexibility intended to make paying the mortgage simpler was often used to buy a bigger house instead. When this happened, the borrower may have believed he was making a rational decision. This was an option made available to him by the bank, and he was certain he could make his payments in the future — because a foreclosure would never happen to him. And of course, the fact that the bank was willing to lend him that maximum amount meant he could afford it, right? Why would the bank lend him more money than he could pay back?

Many people made this type of irrational choice because it was one of the many options available to them. They would certainly have been happier in the long run with a smaller house that they could comfortably pay for, but given extra choices, the optimism bias is likely to kick in and make it difficult to determine what will really make them happy in the future — particularly when a 4,000 square foot house with gleaming marble countertops and a lagoon-like backyard pool is staring them in the face right now.

Analysis Paralysis

Another major reason why borrowers ended up taking on more house/mortgage than they could afford has to do with a common choice problem known as analysis paralysis. Every new employee faced with an overwhelming number of options for enrolling in their company's 401(k) has experienced this paralysis. Making a choice seems too difficult, and so it gets put off.

Barry Schwartz talks about a study of this phenomenon in a TED talk from 2005. A researcher found that for every 10 mutual funds offered by a company's retirement program, employee participation went down 2%. This means that having 50 mutual fund options to choose from means a 10% decrease in participation compared to having only five options. It's much easier to choose the best of five options rather than comb through 50 in order to determine which option is best. So much easier that you're likely to just skip the task altogether if it seems too hard.

I suspect that a similar phenomenon was going on during the housing bubble. The enormous number of mortgage options available was overwhelming to the average borrower. How would she know if it was better to take a tradition mortgage or an ARM or a piggyback mortgage, etc.? But rather than a paralysis that led to no decision whatsoever, this type of analysis paralysis likely made borrowers more susceptible to sales pitches from their banks. With a dizzying number of options, having your friendly neighborhood mortgage lender tell you that Mortgage X was a wonderful option is an easy way to make your choice. No need to investigate the various options — this one is the best, according to the lender.

I saw this type of paralysis first hand when my husband bought his first house (which became ours after we married). He purchased the home in 2005, at the top of the housing bubble, and at the time he had no down payment saved. (You could get away with those kinds of shenanigans back then).

He was offered a huge menu of different potential mortgages, including several adjustable rate mortgages that had incredibly low introductory rates. Staring cross-eyed at the options available to him, he found himself silently screaming, "I just want this house!" Many borrowers, when feeling this sense of helplessness and paralysis, might simply choose whatever option will get them the house for the cheapest amount in the short run.

Luckily, my husband spent a little time researching and took the most conservative option available to a borrower who was putting no money down — a piggyback loan wherein he took out a home equity line of credit to pay for the down payment and a traditional 30-year fixed-rate mortgage for the remaining 80%. But his analysis paralysis could have led to him taking one of the tempting ARM options available, which would have been devastating for us down the road. (As it was, he had two payments to make each month, which was less than ideal.)

Making Rational Decisions

Anyone who has gone mortgage shopping in the last four or five years knows that the wonderland of mortgage options is more limited than it once was. But we still have mortgage choices available to us that would have been completely alien to our parents and grandparents back in the day. Considering the potentially disastrous consequences of making a poor choice, how can we cut through the noise of those extra options?

Richard Thaler, an economist at the University of Chicago Booth School of Business, outlines an intriguing regulation idea in a New York Times article:

Lenders could be required to offer some mortgages they call 'plain vanilla,' with uniform terms. There might be one vanilla 30-year, fixed-rate mortgage and one five-year, adjustable-rate mortgage. The features of these plain mortgages would be uniform, much as in a standard lease used in most rental agreements…Lenders would also be free to offer other exotic mortgages — perhaps called "rocky road" mortgages? — along with the vanilla variety, but these offerings would receive more intense scrutiny from regulators.

Such a regulation would allow first-time borrowers to stick with (and be steered towards) the traditional loans that will work out best for them, while still allowing lenders and experienced borrowers to experiment with other mortgage products.

Unless and until this type of regulation is put in place — and as of right now, the new mortgage rules that will come into effect in 2014 do not include this particular regulation idea — the path for the rest of us is pretty clear.

Stick with the traditional fixed-rate mortgages of our parents' day. Ignoring the other options available to you is probably the best choice of all.

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Carla

While I appreciate your well-meaning advice, you speak entirely too broadly and without enough experience. Why would an ARM loan have been disastrous for you? Rates have steadily fallen since 2005, and you would probably be paying around 2.5% interest right now without ever having refinanced. Your rate probably wouldn't have even adjusted until 2010, so you would have missed the worst parts of the market. Regulations are already strangling the mortgage industry, and the new "qualified" mortgage stands to cut thousands if not millions of borrowers out of the market. ARM loans and their counterparts are valuable tools that allow banks to advance capital to riskier borrowers who will most likely refinance within 5-7 years. Eliminating those tools, and enforcing strict repayment rules will leave many people in serious trouble. We see everyday people who are struggling to make mortgage payments for any variety of reasons, and who are stuck paying 4%, 5%, or even 7-8% interest rates because they aren't "qualified" to refinance because of new regulations. I spend my days processing approximately 40 disclosures per customer, then taking those customers phone calls because they didn't understand the disclosures in the first place. Demanding that the government make more rules will not benefit you in the long run. Demanding that the populace be educated, however, will help everyone. If you want the government to solve people's financial problems, demand that finance classes become standard high school fare. Students should not graduate into the real world until they can balance a check book and explain a balloon loan. But the knee-jerk reaction of "control the things I don't understand!" may serve to make you more comfortable, but it will hurt a lot of people who rely on those sorts of loans to stay in their homes.

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Carla makes a very good point here with her comments. An ARM gets such a terrible reputation in the market but it's only because people don't know the function of an ARM. There is almost always a cap on the highest possible rate someone could pay and many times it is lower than the rate they are currently in with their mortgage now. With rates where they are today ARM's are not such a good choice but that is only because you can get a fixed rate for almost nothing. If rates go back up into the mid 4's to mid 5's a 7 year ARM would be a great choice for a first time home buyer that is looking to move into a larger home in 4-5 years. People just need to keep their mind open and learn as much as they can about the various mortgage products and determine which one fits their needs.