The promise we all make to ourselves
When building a mortgage mixture, there's a strong temptation to choose a fixed-rate loan track for a short term. It makes sense: the shorter the loan term, the lower the interest rate you get — for example, a 10-year track will carry a lower rate than a 20-year track.
With that in mind, quite a few people include a short-term fixed-rate loan in their mortgage mixture while stretching the rest of it — the non-fixed parts — over long terms, usually 25 to 30 years.
And that's where the trouble starts: most of the mortgage ends up running for a very long time, the principal in those parts barely shrinks over the years, and the accumulated interest is high. When you ask the borrower about this, the answer is usually ready and waiting: "Once the short track ends and the monthly payment drops, we'll bump the payment back up, pay off the remaining loans faster, and take care of it later."
On paper the plan sounds good. In reality, it almost never happens.
What is the diagnosis? "Hyperbolic discounting"
Economist Richard Thaler, winner of the 2017 Nobel Prize in Economics, was one of the leading researchers who developed this theory as part of his work on behavioral economics.
We all know we have self-control problems. Have you ever promised yourself that you'd start a diet after the holidays? Or that you'd get back in shape and run twice a week once the holidays were over? Or that once you finished your degree, your military service, your internship, and so on, you'd finally quit smoking?
We know we have. We've been trying to get back in shape for years, and every time there's a new excuse not to.
The pattern is always the same:we set an ambitious goal that we'll commit to in the future — the more distant, the better. Have you ever asked yourself why we don't commit to starting to exercise tonight? Or why we don't quit smoking right now? Because the effort feels too great, so it's easy to rope our future "selves" into the commitment. After all, our future "self" (the one after the holidays) can't object to a deal we sign today.
But that future "self" doesn't actually want to commit to these goals. That's why the diets fail and our waistlines keep expanding over the years. Our preferences change over time.
How does this relate to your mortgage?
When you take out a mortgage with a plan to "handle it later" — whether that means raising the monthly payment once a loan ends, making an early prepayment with a bonus you receive, or refinancing when interest rates fall — you're essentially betting that your future self will keep the promises your present self is making.
But in a few years, when it's time to act, you'll want to do something else with your money. You'll want to fly the family to Thailand, upgrade the car, renovate the kitchen, put the money into the market, and so on. That's reasonable, and it's human.
Hyperbolic discounting shows up in plenty of other corners of our financial lives. Self-employed people don't save for retirement today because they're convinced they'll do it later, putting their future "selves" at real risk. Another example is the way we ignore our annual pension statements, because we figure there'll be a better time to deal with them down the road.
What can be done? Odysseus's commitment strategy
Probably the earliest account of someone wrestling with self-control problems is Odysseus from Greek mythology. On his sea voyages, Odysseus wanted to hear the song of the Sirens. At the same time, he knew that anyone who hears their heavenly singing becomes addicted to it, loses all self-control, and steers their ship onto the rocks to their inevitable death.
Since Odysseus wasn't willing to give up the pleasure, he adopted a "commitment strategy" — in other words, he limited his own choices.
The idea was formally developed by economist Thomas Schelling, who showed how people use self-imposed constraints to overcome the internal conflict between their present "self" and their future "self."
Odysseus chose this strategy to keep himself from harm. He ordered his crew to tie him to the mast and to plug their own ears with wax. When they sailed past the Sirens, Odysseus got to hear their heavenly singing, but he couldn't harm himself, his ship, or his crew — he couldn't move, and his crew couldn't hear him.
The solution: committing our future self to promises we will keep
Back to our mortgage. We need to keep our future self from doing something foolish and blowing up the plans we made.
The principle is simple: don't build a mortgage mixture that relies on actions you'll have to take down the road.
If your plan calls for you to raise the monthly payment, make an early prepayment, or refinance a few years from now, assume it probably won't happen. Instead, build a mortgage mixture that works even without any future intervention from you — one that locks you into the right monthly payment from day one.
Granted, this sometimes means a slightly higher interest rate on the fixed loans, which never feels great — but it's how you protect yourself from yourself.
And one last small but interesting aside: psychologist Walter Mischel proved in the famous marshmallow experiment that our ability to delay gratification is tied to important life outcomes. For instance, the kids who showed more self-control went on to earn higher psychometric test scores! What's true for your mortgage is true for plenty of other areas of life as well.
To see how different mortgage mixtures affect your monthly payment and total cost, try building yours in the mortgage calculator.
Good luck!