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1.3.3.1 Barriers to Consumer Decision-Making

One argument for unfettered lending is that consumers, as informed and rational decision makers, will insure that the mortgage market is operating properly. But the lesson of the recent foreclosure crisis is that this is not true. For a borrower’s contractual “choice” to have any meaning, borrowers must be able to evaluate the risks and benefits of the credit offered. Borrowers must also have meaningful alternatives to the credit presented. Neither of these conditions were present for many borrowers during the previous decade,249 and there is little indication that situation will change in the future.

The fiction of informed choice often collapses entirely for vulnerable consumers. The 1992 National Assessment of Adult Literacy used a typical advertisement for a home equity loan as one of its measures of “quantitative literacy.” Only four percent of the adults sampled could calculate how much interest would be charged.250

An assessment conducted in the 2010s found that seventeen percent of U.S. adults scored in the bottom levels for literacy and twenty-seven percent for numeracy.251 Consumers with scores that low would not be able to understand the terms and conditions in a typical contract. The documents involved in a typical mortgage transaction are incomprehensible to even better educated consumers252 and are written in language far beyond what the average American can read and understand. Pricing is sufficiently complex that it can puzzle economics professors.253

In 2009, the Chairman of the Federal Reserve Board acknowledged that no amount of disclosure would be enough to enable most consumers to understand some financial products.254 Moderately complex products, like adjustable rate mortgages, are completely beyond consumers’ limited financial and quantitative literacy.255 The surge in what are charitably called “nontraditional” mortgage products leading up to the economic collapse in 2007 exploited gaps in consumer understanding.256 These products typically multiplied the inherent complexity of an adjustable rate mortgage (ARM) by layering other complex and risky traits on top.257 By 2007, the two most common types of new, risky loan products were the payment option ARM and the interest-only ARM. But other variations, including forty-year and interest-only mortgages, also gained significant market share in the years leading up to the market crash in 2007.258 Without doubt, neither creditors nor consumers understood the products nor the risks inherent in them.259 Few borrowers would have chosen these mortgages had they understood the risks.260

At the peak of the last mortgage bubble, many borrowers, but particularly African Americans and Latinos, had a misplaced faith that lenders would—indeed were required to—provide the best rates.261 According to the mortgage industry’s own analysis, nearly forty percent of all mortgage borrowers were confused by the process.262 Unsurprisingly, consumers with the worst quantitative literacy were the most likely to default on risky products like subprime mortgages and the most likely to engage in multiple cash-out refinancings of their homes.263

Legal scholars and behavioral economists have applied well-established insights of psychology to demonstrate that many, if not most, consumers make systematic errors of judgment in evaluating credit.264 Most consumers, even educated consumers, focus on the payment to estimate the cost of a loan.265 This focus on the payment works fine as a shortcut if the loans being compared are fixed rate loans of the same length and principal amount. But it gravely misleads borrowers comparing loans of different lengths or with adjustable rate periods. Worse, virtually all consumers, when given a payment stream, underestimate the effective interest, on average by as much as thirty-eight percent.266 Because credit defers payments into the future, most consumers heavily discount the actual cost of repaying that credit.

Similarly, consumers are not well equipped to judge the tax advantages of refinancing other forms of credit into mortgage loans when the interest is tax deductible. Any potential tax savings must be weighed against the extra interest charged and the fees to be paid for such loans. Moreover, the benefits of the mortgage interest deduction are not evenly distributed among taxpayers. Only individuals who itemize deductions can take advantage of it and the value of the deduction increases with the marginal tax rate (and thus as income increases).267

An unregulated free market system rewards creditors who understand and take advantage of these systematic biases to hide the real cost of credit.268 Little wonder then that many creditors understate or obscure the real cost of credit.269

Footnotes

  • 249 {249} Richard Lord, American Nightmare: Predatory Lending and the Foreclosure of the American Dream (2005); Kathleen C. Engel & Patricia A. McCoy, A Tale of Three Markets: The Law and Economics of Predatory Lending, 80 Tex. L. Rev. 1255 (2002); Patricia A. McCoy, Rethinking Disclosure in a World of Risk-Based Pricing, 44 Harv. J. on Legis. 123, 139–149 (2007) (discussing lack of price transparency); Elizabeth Renuart, An Overview of the Predatory Lending Process, 15 Hous. Pol’y Debate 467 (2004). Cf. Sumit Agarwal, John C. Driscoll, Xavier Gabaix, & David Laibson, The Age of Reason: Financial Decisions Over the Lifecycle 37 (Feb. 11, 2008), available at http://ssrn.com.

  • 250 {250} Nat’l Ctr. for Educ. Statistics, Adult Literacy in America 100 (Sept. 1993) (the advertisement included all the information necessary to make the calculation: number and amount of monthly payments, and loan principal). Cf. Annamaria Lusardi & Olivia S. Mitchell, Baby Boomer Retirement Security: The Roles of Planning, Financial Literacy, and Housing Wealth, 54 J. Monetary Econ. 205, 207, 216 (2007) (less than 18% of surveyed adults between the ages of fifty-one and fifty-six could calculate compound interest at 10% on $200 over two years); Annamaria Lusardi & Olivia S. Mitchell, Pension Research Council, Working Paper No. 1, Financial Literacy and Planning: Implications for Retirement Wellbeing 4, 7 (2006), available at www.dartmouth.edu (noting that only 67% of surveyed adults, many over fifty, could correctly determine whether, after five years of interest at 2% on $100, they would have less than, more than, or exactly $102); Macro Int’l, Inc., Design and Testing of Effective Truth in Lending Disclosures 52 (2007), available at www.federalreserve.gov (“very few participants could accurately describe how interest charges were accurately calculated”); Danna Moore, Wash. State Univ., Soc. & Econ. Sci. Research Ctr., Tech. Rep. No. 03-39, Survey of Financial Literacy in Washington State: Knowledge, Behavior, Attitudes, and Experiences (2003) (finding approximately 30% of respondents do not understand that if interest compounds, it builds on itself).

  • 251 {251} Nat’l Center for Educ. Statistics, Program for the International Assessment of Adult Competencies (2012/2014/2017), available at https://nces.ed.gov.

    A 2003 study, not directly comparable to more recent studies, found that 14% of adults in the United States were functionally illiterate. Nat’l Ctr. for Educ. Statistics, National Assessment of Adult Literacy (2003), available at http://nces.ed.gov. Based on this study, the most difficult tasks that an estimated ninety million adults could perform include calculating the difference in price of two items and filling out a Social Security form. These adults cannot write a brief letter explaining an error in a credit card bill, figure out a Saturday departure on a bus schedule, or use a calculator to determine the difference between a sale price and a regular price.

  • 252 {252} Unsophisticated consumers are not alone in this problem. As Deputy Treasury Secretary Neal S. Wolin said of his own mortgage closing: “The documents are literally impenetrable. . . . Here I was—former general counsel of the Treasury, former general counsel of a Fortune 100 financial services company—asking my lawyer to help me through 100 pages of incomprehensible, turgid gobbledygook.” Sewell Chan, Trench Warfare: Send in the Deputies, N.Y. Times, Apr. 16, 2010.

  • 253 {253} See, e.g., Michael LaCour-Little & Cynthia Holmes, Prepayment Penalties in Residential Contracts: A Cost-Benefit Analysis, 19 Hous. Pol’y Debate 631, 631–632 (2008) (“Given the embedded options they contain, mortgages are among the most complex of financial instruments.”).

  • 254 {254} Ben S. Bernanke, Chairman, Fed. Reserve Bd., Address at the Federal Reserve Community Affairs Conference 4 (Apr. 17, 2009), available at www.federalreserve.gov (“[S]ome aspects of increasingly complex products simply cannot be adequately understood or evaluated by most consumers, no matter how clear the disclosure.”). See James M. Lacko & Janis K. Pappalardo, Fed. Trade Comm’n, Improving Consumer Mortgage Disclosure: An Empirical Assessment of Current and Prototype Disclosure Forms, at ES-11 (2007), available at www.ftc.gov (prime borrowers have difficulty answering questions about their loans; difficulty increases as loan becomes more complex); William C. Apgar, Allegra Calder, & Gary Fauth, Jt. Ctr. for Hous. Studies, Harvard Univ., Credit, Capital and Communities: The Implications of the Changing Mortgage Banking Industry for Community Based Organizations 40, 50–51 (Mar. 2004) (discussing inability of even sophisticated consumers to understand mortgage products). See also Dee Pridgen, Sea Changes in Consumer Protection: Stronger Agency and Stronger Laws, 13 Wyo. L. Rev. 405, 416–419 (2013) (describing consumer limits and the limitations of disclosure); Comments of the Ctr. for Responsible Lending on Advance Notice of Proposed Rule-Making, Regulation Z, Subpart B: Open-End Credit 22 (Mar. 28, 2005) (“[C]ollege-educated consumers consistently underestimate[] how long it would take to pay off credit card balances.”).

  • 255 {255} See Brian Bucks & Karen Pence, Fed. Reserve Bd. of Governors Fin. & Econ. Discussion Series Working Paper No. 2006-3, Do Homeowners Know Their House Values and Mortgage Terms? 18–22 (2006), available at www.federalreserve.gov (borrowers, particularly low-income borrowers, underestimate caps on life time interest rates in adjustable rate mortgages); Consumer Fed’n of Am., Lower-Income and Minority Consumers Most Likely to Prefer and Underestimate Risks of Adjustable Mortgages 3 (July 26, 2004) (consumers cannot calculate the increase in the payment in an adjustable rate mortgage and minimize the interest rate risk by understating the increase in the payment; problem is present for all categories, but particularly pronounced for younger, poorer, less educated, and non-white consumers).

  • 256 {256} See Oren Bar-Gill, The Law, Economics, and Psychology of Subprime Mortgage Contracts, 94 Cornell L. Rev. 1073 (2009).

  • 257 {257} U.S. Gov’t Accountability Office, Pub. No. GAO 06-1021, Alternative Mortgage Products: Impact on Defaults Remains Unclear, But Disclosure of Risks to Borrowers Could Be Improved 12–14 (2006), available at www.gao.gov.

  • 258 {258} Id.

  • 259 {259} See, e.g., Oren Bar-Gill, The Law, Economics, and Psychology of Subprime Mortgage Contracts, 94 Cornell L. Rev. 1073, 1081–1082 (2009) (“The multibillion dollar losses incurred by these sophisticated players provide (at least suggestive) evidence that imperfect rationality was not confined to the demand side of the subprime market.”); 8 Billion in Mortgage Overcharges Seen, L.A. Times, June 30, 1990, at D-5 (reporting on studies showing errors in computing payments on adjustable rate loans in over half of 7000 loans sampled). Cf. Interagency Guidance on Nontraditional Mortgage Product Risks, 71 Fed. Reg. 58,609, 58,616 (Oct. 4, 2006) (lenders “should recognize that their limited performance history with [nontraditional mortgages] . . . increases performance uncertainty,” and “consumers may not fully understand these products”).

  • 260 {260} See Ronnie Cohen & Shannon O’Byrne, Burning Down the House: Law, Emotion, and the Subprime Mortgage Crisis, 45 Real Prop. Tr. & Est. L.J. 677, 703–716 (2010–2011) (describing how lenders and brokers undermined borrowers’ understanding of their mortgage loans by taking advantage of future cost discounting, information asymmetry, lack of expertise, and their emotional desire to own a home). Cf. Kristopher Gerardi, Lorenz Goette, & Stephan Meier, Fed. Reserve Bank of Atlanta, Working Paper No. 2010-10, Financial Literacy and Subprime Mortgage Delinquency: Evidence from a Survey Matched to Administrative Data 15 (2010), available at https://www.frbatlanta.org (reporting that average interviewee, a borrower with a subprime mortgage originated in 2006 or 2007 when most subprime mortgages were adjustable rate mortgages, would chose a thirty-year fixed mortgage over a mortgage that adjusts after two years, if there is 50-50 chance that the mortgage payment will either increase by more than $184 dollars a month or decrease by $500 a month).

  • 261 {261} Mortgage Foreclosure Filings in Pennsylvania: A Study by The Reinvestment Fund for the Pennsylvania Department of Banking 74 (Mar. 2005), available at https://www.reinvestment.com (citing Fannie Mae’s 2002 National Housing Survey). Cf. Martinez v. Freedom Mortg. Team, Inc., 527 F. Supp. 2d 827 (N.D. Ill. 2007) (Hispanic borrower’s belief that broker would not arrange and lender would not originate loan borrower could not afford was reasonable); 74 Fed. Reg. 44,522, 44,542 (July 30, 2008) (“Borrowers could reasonably infer from a lender’s approval of their applications that the lender had appropriately determined that they would be able to repay their loans.”); id. at 44,564–44,565 (discussing consumer testing showing that many consumers believe that brokers are “obliged to find them the lowest interest rates and best terms available”).

  • 262 {262} According to a survey commissioned by the Mortgage Bankers of America, “4 out of 10 borrowers indicate some level of confusion with the loan process” and “31% of all borrowers stated that the biggest hurdle of the process was understanding and completing the paperwork, while 17% had difficulty determining how much their loan would cost.” Homebuyers and the Loan Settlement Process: A Yankelovich CNN Study, prepared for the Mortgage Bankers Ass’n of Am., at 48 (Mar. 5, 1997). Given the proclivity of many of us to want to minimize our weaknesses, we can safely assume that some additional number of mortgage borrowers were also confused, but were too embarrassed to admit it.

  • 263 {263} Kristopher Gerardi, Lorenz Goette, & Stephan Meier, Fed. Reserve Bank of Atlanta, Working Paper No. 2010-10, Financial Literacy and Subprime Mortgage Delinquency: Evidence from a Survey Matched to Administrative Data 4–5, 17 (2010), available at https://www.frbatlanta.org (finding a strong and statistically significant correlation between interviewees holding subprime mortgages who defaulted and those who had difficulty with simple math questions such as finding ten percent of 1000, holding constant for income, education, credit score at time of origination, and other factors; interviewees in the bottom quartile of quantitative literacy were fifteen percentage points more likely to experience foreclosure or be behind in their payments than those in the top quartile).

  • 264 {264} E.g., Oren Bar-Gill, The Behavioral Economics of Consumer Contracts, 92 Minn. L. Rev. 749, 761–765 (2008); Oren Bar-Gill, Bundling and Consumer Misperception, 73 U. Chi. L. Rev. 33, 45 (2006); Oren Bar-Gill, Seduction by Plastic, 98 Nw. U. L. Rev. 1373 (2004); Susan Block-Lieb, The Myth of the Rational Borrower: Rationality, Behavioralism, and the Misguided “Reform” of Bankruptcy Law, 84 Tex. L. Rev. 1481 (2006); Matthew A. Edwards, Empirical and Behavioral Critiques of Mandatory Disclosure: Socio-Economics and the Quest for Truth in Lending, 14 Cornell J.L. & Pub. Pol’y 199, 221–223 (2005); Jason J. Kilborn, Behavioral Economics, Overindebtedness & Comparative Consumer Bankruptcy: Searching for Causes and Evaluating Solutions, 22 Emory Bankr. Dev. J. 13, 18–19 (2005); Yoon-Ho Alex Lee & K. Jeremy Ko, Consumer Mistakes in the Mortgage Market: Choosing Unwisely Versus Not Switching Wisely, 14 U. Pa. J. Bus. L. 417, 428–435 (2013) (maintaining that consumers’ lack of expertise and information about loan products results in consumer losses both when choosing an initial mortgage loan and when deciding whether to refinance); Patricia A. McCoy, Elder Law: A Behavioral Analysis of Predatory Lending, 38 Akron L. Rev. 725, 734 (2005) (detailing the difficulties faced by shoppers for subprime mortgage loans); Elizabeth Renuart & Diane E. Thompson, The Truth, the Whole Truth and Nothing But the Truth: Fulfilling the Promise of Truth in Lending, 25 Yale J. on Reg. 181 (2008); Jeff Sovern, Toward a Theory of Warranties in Sales of New Homes: Housing the Implied Warranty Advocates, Law and Economics Mavens, and Consumer Psychologists Under One Roof, 1993 Wis. L. Rev. 13 (1993); Lauren E. Willis, Decisionmaking and the Limits of Disclosure: The Problem of Predatory Lending: Price, 65 Md. L. Rev. 707 (2006); Ren S. Essene & William Apgar, Joint Ctr. for Hous. Studies, Harvard Univ., Understanding Mortgage Market Behavior: Creating Good Mortgage Options for All Americans (2007).

  • 265 {265} See, e.g., Lauren E. Willis, Decisionmaking and the Limits of Disclosure: The Problem of Predatory Lending: Price, 65 Md. L. Rev. 707 (2006); Ren S. Essene & William Apgar, Joint Ctr. for Hous. Studies, Harvard Univ., Understanding Mortgage Market Behavior: Creating Good Mortgage Options for All Americans (2007).

  • 266 {266} The median underestimation was twenty-five percent. Victor Stango & Jonathan Zinman, How a Cognitive Bias Shapes Competition: Evidence from Consumer Credit Markets 3–4 (Sept. 5, 2006).

  • 267 {267} Bruce Katz, Brookings Inst., Reform the Mortgage Interest Deduction to Invest in Innovation and Advanced Industries 2 (2012); Eric Toder, et al., Urban Inst., Reforming the Mortgage Interest Deduction (Apr. 1, 2010).

  • 268 {268} See Oren Bar-Gill, The Behavioral Economics of Consumer Contracts, 92 Minn. L. Rev. 749, 789 (2008) (arguing that consumer misperceptions cause market distortions in pricing and other attributes of credit); Oren Bar-Gill, The Law, Economics, and Psychology of Subprime Mortgage Contracts, 94 Cornell L. Rev. 1073, 1083–1084 (2009) (“enhanced competition” likely increases prevalence of complexity and cost deferral in subprime mortgages).

  • 269 {269} See, e.g., Miller v. Americor Lending Group, Inc., 2007 WL 107664 (W.D. Mich. Jan. 9, 2007) (broker offers to arrange fixed-rate, non-negatively amortizing, pick-a-payment 2% interest rate loan and provides initial Truth in Lending Act disclosures, although knew no such loan existed); Fed. Trade Comm’n v. Chase Fin. Funding, Inc., No. SACV04-549, Complaint, at 4 (C.D. Cal. May 12, 2004), available at www.ftc.gov (adjustable rate mortgage with initial minimum payment, based on interest at 3.5% amortized over thirty years, which results in negative amortization, because actual interest rate is much higher, advertised as “3.5% fixed payment 30 year loan”); Nationscapital Mortg. Corp. v. State Dep’t of Fin. Inst., 137 P.3d 78, 83–84 (Wash. Ct. App. 2006) (broker apparently had pattern of representing on Truth in Lending Act disclosures that borrower was not responsible for broker fee); John R. Wilke, Hidden Fees in Most Mortgages Bring Scrutiny to Fannie, Freddie, Wall St. J., Jan. 14, 2005, at A1 (reporting on guarantee fees paid by lenders to Fannie Mae and Freddie Mac that are packaged in the interest rate and not disclosed to borrowers; averaging two-tenths of a percent of the loan amount per month); Gov’t Accountability Office, GAO No. 06-1021, Alternative Mortgage Products: Impact on Defaults Remains Unclear, But Disclosure of Risks to Borrowers Could Be Improved 22 (2006), available at www.gao.gov (describing advertisement for payment-option ARM that promised 45% reduction in monthly mortgage payments and interest rate of 1.25%; interest rate of 1.25% only applied for first month, and this fact disclosed in “much smaller print” on second page). Cf. Patricia A. McCoy, Rethinking Disclosure in a World of Risk-Based Pricing, 44 Harv. J. on Legis. 123, 128–138, 142–143 (2007) (discussing limitations of current disclosure regime in providing relevant, binding information in a timely and useful manner).