How do policymakers encourage people to make better decisions about their mortgage?
Buying a home is the most important financial decision the average person makes in their lifetime. The choice will affect their finances for decades, and, worryingly for regulators, the sum of a population’s decisions can have a profound impact on the wider economy.
As such, policymakers across the globe often find themselves searching for ways to shore up potential risks by nudging people towards better financial decisions. For mortgages, a transaction that many find complicated and intimidating, theories and expectations can only go so far.
Instead, empirical research designed to specifically understand exactly what goes through the average person’s mind when they buy a house is necessary to making effective policy changes. Two pieces of work undertaken by researchers from Imperial College Business School, both using a similar philosophy, have revealed very different answers for different countries.
In 2004, David Miles, Professor of Financial Economics at Imperial College Business School, was commissioned by Gordon Brown, then Chancellor of the Exchequer, to review the structure of the UK’s mortgage market. The review’s research made clear that many people struggle to understand the costs and risks of a mortgage. Many based their decision on the level of initial monthly repayments as opposed to the lifetime borrowing cost of the loan, and others did not understand how future changes in the interest rate could affect the value of their investment.
“The thing that is particularly difficult for people to work out is: What changes will there be three, four or five years in the future?” Professor Miles said. “Even financial market professionals are often spectacularly wrong about things like where the level of interest rates will go. How could you expect households to be as well informed as them?”
Research designed to specifically understand exactly what goes through the average person’s mind when they buy a house is necessary to making effective policy changes
Among the changes implemented in the UK’s 2014 Mortgage Market Review, which was based on Professor Miles’ work, borrowers now go through a stress-test to see how they would manage a significant increase in the interest rate. Miles believes that this is particularly important in the current financial environment where rates are at an historic low.
“It's pretty much inevitable that from here, maybe not over the next 12 months but over the next few years, rates are going to go up, and maybe go up a lot,” Professor Miles said.
“Hopefully we'll be in a situation where we may avoid what has happened many times in the history of the UK, which is when interest rates go up significantly many households really struggle to pay the mortgage.”
Helping Indian households finance their needs
The same research philosophy is now leading to similar reforms on the other side of the world. Tarun Ramadorai, Professor of Financial Economics at Imperial College London, was given a similar, albeit broader, mandate in 2016 by Raghuram Rajan, Governor of the Reserve Bank of India.
Taking the same approach of analysing real-world behaviour, the Ramadorai Committee made a sweeping selection of policy recommendations covering the insurance, credit, and asset markets.
Professor Ramadorai said his committee ultimately sought the answer to two core questions: “What does a typical Indian household balance sheet look like, and what changes are required to best enable Indian households to finance their needs?”
Mortgage credit occupies a fairly low share of the average Indian household's balance sheet, but the report included the significant recommendation that all mortgages being sold be quoted against a common benchmark.
The Ramadorai Committee made a sweeping selection of policy recommendations covering the insurance, credit, and asset markets
“The big problem with consumer choice is if households are offered a set of very confusingly labelled options which are incommensurable, then it becomes difficult for them to ascertain which product is actually the best one for them,” Professor Ramadorai said. “By putting all of the products on a level playing field it aids mortgage choice a great deal.”
The change also aids monetary policy. “The central bank no longer has to pull multiple levers in order to get monetary policy transmission through to the average household budget,” Professor Ramadorai explained. “Now they have only one lever to pull, which is much more effective.”
Behind future interest rate rises lurks the next potential financial crisis, but empirical research into how people actually behave, not just what they are expected to think or do, is designing better policies across the globe.