Suppose you learned that during the recent recession the national government adopted a policy that cost American homeowners $5.4 billion. Or that the nation’s banks adopted a policy that had exactly the same effect. You’d probably be outraged. Fortunately, that didn’t quite happen, but something similar did. Whether or not it’s outrageous, we should do something about it.
For many people, buying a home is the most important financial decision they ever make. Interest rates rise and fall, and when they fall, many homeowners have an opportunity to refinance and to save a lot of money. From 2010 to 2012, rates dropped significantly. In late 2012, they reached an all-time low, falling well below 4 percent. Someone whose original loan came with a rate of 6.5 percent could, by refinancing, save more than $100,000 over the life of the loan.
The standard economic assumption is that homeowners consider such benefits and make rational decisions about whether and when to refinance. But behavioral economists suspect this isn’t what really happens – that lots of people fail to refinance even when they stand to save many thousands of dollars.
Some procrastinate, thinking that they will refinance tomorrow – and tomorrow never comes. Some focus on the upfront expense of refinancing, and the inconvenience of the process, discounting the long-term economic gains. (This is known as “present bias.”) Anecdotal evidence supports this speculation, but there has been a lack of systemic research.
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Until now. Economists Benjamin Keys and Devin Pope of the University of Chicago, along with Jaren Pope of Brigham Young University, studied a nationally representative sample of about 1 million residential mortgages that were active in December 2010. Keys and his colleagues were able to obtain a lot of information about these loans, including the interest rate, the payment history, any second liens and the existing balance. As a result, they could make reasonable judgments about which homeowners were unable to refinance (because of their economic circumstances) and which would benefit from doing so.
Of the many who stood to save tens of thousands of dollars by refinancing, 20 percent sat on their hands. Nationwide, the researchers concluded from these findings, Americans mortgage-holders who neglected to refinance passed up a total of $5.4 billion in savings – and that is a conservative estimate.
What happened to that 20 percent by late December 2012, when interest rates bottomed out? Two in five of them had still neglected to refinance, even though their potential savings grew.
The homeowners who failed to refinance tended to be the ones with relatively less wealth and less education. In other words, the people most in need of saving money were the least likely to do so. It follows that poor refinancing decisions exacerbate economic inequality.
Keys and his colleagues went a step further. Working with a nonprofit corporation, they wrote letters to mortgage holders in lower-income communities offering to refinance their loans at a lower rate. These pre-approved offers promised potentially substantial savings, and yet 84 percent of recipients didn’t respond. A follow-up survey found that 25 percent of the nonresponders didn’t even open the letter, and 33 percent planned to call the loan officer but never did so.
Obviously, we can’t blame banks for people’s poor decisions. Yet there are many ways that banks could help to promote refinancing – for instance by making it easier or even automatic (when rates decline by a certain amount), or by providing clear, simple, accessible information. And with appropriate incentives, government policy could encourage banks to do these things.
If one of our goals is to help struggling homeowners, we could do a great deal, certainly in the future but even now, by encouraging and simplifying refinancing. A number of homeowners continue to have mortgages with rates significantly above those now available (which recently dropped to a low for the year). And the new research raises an intriguing question: In what other contexts are low take-up rates leading people to leave a lot of money on the table?
Cass R. Sunstein, the former administrator of the White House Office of Information and Regulatory Affairs, is a professor at Harvard Law School and a Bloomberg View columnist.