A mortgage is much more than math and numbers
We began working in the field of behavioral economics after analyzing hundreds of mortgage mixtures. These analyses gave us the opportunity to speak with people from every walk of life. We spoke with high-tech workers and manufacturers, with chefs and soldiers, with suited lawyers and bored pensioners. We advised people with impressive financial and economic knowledge and complete novices alike. Everyone made the same mistakes — over and over and over.
It was driving us crazy. We'd explain to people why their plans weren't realistic — and they'd explain right back why we were the ones who had it wrong. When we pointed out the holes in their strategy and their mortgage mixture, our arguments got waved away. We'd use examples from their own lives to show them the mistake — and the answer was always the same: "With a mortgage it's different."
Everything changed after we were exposed to research in the field of behavioral economics. Papers by Richard Thaler, winner of the Nobel Prize in Economics in 2017, and Daniel Kahneman, winner of the Nobel Prize in Economics in 2002, provided the academic explanations for phenomena we had encountered and would continue to encounter day after day. What could be seen in practice had been researched and proved theoretically.
Misbehaving — Richard Thaler
In his fascinating book, "Misbehaving", about the development of behavioral economics, Richard Thaler describes how the academic community rejected him and his ideas for many years. Much time passed before his findings about the inaccuracy of the economic models we had been using began to receive the recognition they deserved. Today, there are teams in governments and large organizations that use tools from this field to implement and embed meaningful processes.
A mortgage is not just numbers
We ignore the truth - we are human beings with weaknesses and desires. We are convinced that our behavior is completely rational - even though that behavior is proven again and again to be incorrect. Therefore, we decided to bring theory into practice and change the way a mortgage is taken out in Israel. We decided to challenge the working methods of the banks and of some professionals, simply because the thinking that drives us is that there is no other way. You cannot build a mortgage mixture without taking into account the issues described below.
In supporting our arguments, we rely on very high authority. It is not us - these are Nobel Prize winners. Behavioral economics has changed our lives completely:
- The British government incorporates teams of behavioral economists to improve tax collection rates.
- Investment and pension companies use tools from behavioral economics to encourage us to increase our pension savings rates.
Our goal is this: to bring into awareness the behavioral errors that all of us make, and thereby help identify and avoid them before they occur. On a more practical note, we want to clarify for you what the behavioral pitfalls are that will damage your mortgage.
A review of the accepted economic models
Richard Thaler devoted his academic life to proving that we do not behave according to the accepted economic models. What are those accepted economic models?
First, the assumption at the foundation of classical economic theory is that we as consumers are:
- Perfectly rational (Perfect Rationality) - meaning capable of processing all relevant information.
- Utility maximizers (Utility Maximizer) - choosing the basket of goods that gives us the greatest well-being, precisely.
- Perfectly informed (Perfect Information) - knowing all prices, all alternatives, and the utility of every product.
- Endowed with unlimited computing ability - we have no time constraints, processing limitations, or uncertainty.
We are supposed to be able to work within the framework of "constrained optimization": that is, if we receive only 800 NIS (this is the constraint) for our weekly grocery budget, we should be able, from among the tens of thousands of products in the store, to choose the best and most appropriate basket of food for our family (this is the optimization) and use every last NIS of that 800. Of course we would manage to do that, right?
In addition, the classical economic models are based on the assumption that we have no self-control problems. If we have chosen to carry out a certain plan, we will stick to it without difficulty and nothing will divert us from the goal. So if we decide to start a new diet, there is no chance that a tray of fresh pastries, in the morning, outside our office will tempt us to break the diet. Right? Of course we will hold firm!
Finally, basic economic theory claims that we will always see the "full" picture in managing our financial affairs. We will know how to move money from place to place to meet our financial goals. So, for example, we would immediately redeem the children's savings deposit earning a modest 1% return in order to repay an expensive loan carrying a 5% interest rate. Of course we would do that, right?
If you really do manage to act as described in the paragraphs above, then congratulations - you are an "Econ" (as Daniel Kahneman defines it in his book "Thinking, Fast and Slow"). You operate rationally and deliberately, and you are probably the only ones in the world who do. The following sections are not intended for you, because you are able to see the benefit in every situation, ignore your human weaknesses, deal with and avoid psychological traps, and process complex problems in your mind with ease.
What we really are - "Humans"
From our experience in interactions with the people around us - there is no one who behaves rationally the way the economics textbooks describe. Our human limitations lead us to make mistakes of our own making that hurt our mortgage — and, beyond that, can damage our finances as a whole. We are "Humans" — that is, driven by our weaknesses, impulses, and desires.
Therefore, the economic model we want to work with is that of bounded rationality.
To cope with these limitations, people use heuristics - mental shortcuts and rules of thumb that allow quick decisions without deep analysis. For example, instead of comparing all the mortgages on the market, a borrower might simply choose the bank where they hold their account or go by a friend's recommendation.
Herbert Simon (1916-2001) was an American economist and psychologist who won the Nobel Prize in Economics in 1978 for his research into decision-making processes in organizations.
Every financial decision we make, as a product of bounded rationality, carries great danger for us when we are planning our mortgage. The only way to avoid these mistakes is to be aware of them. The "wisdom of the crowd" that is accessible to all of us in internet forums can cause us all to make decisions that look good, but beneath the surface are simply expensive.
Behavioral economics and our mortgage
In the following units, we will describe concepts from the field of behavioral economics and explain how they affect our mortgage. We will see that their influence extends to all of our financial behavior.
- Framing bias:We have difficulty seeing the full picture. We will focus only on a small part of it - because that is the part that will be emphasized to us. This phenomenon means that the bank's onboarding loans, the mortgage signing bonus, loans from a study fund instead of the mortgage, and loans from family all look very tempting and correct, but they can end up causing more harm than good.
- Heuristics and biases: Because of our inability to deal with complex problems, we will use mental shortcuts. This causes us to make incorrect and inaccurate comparisons of the mortgage. For this reason, we must not compare mortgages on the basis of the interest rates we received.
- Prospect theory: Despite our fear of losses and our desire to seek certain outcomes, we must not, in moments of high inflation and/or rising interest rates, redeem a study fund in order to reduce our outstanding balance with the bank.
- Hyperbolic discounting: We all have self-control problems. We must not lie to ourselves. We will almost never carry out the self-improvement plans we have set for ourselves. Precisely because of this problem, the right thing to do is to reject the mortgage mixture that will be offered to us by the bank, because it will ultimately be the most expensive.
- Prospect theory and retirement savings: If we return again to prospect theory, we will see how we can end up damaging our retirement savings when we want to finish the mortgage quickly.
Good luck — let's begin.