The Structure of Your Mortgage Mixture Matters Far More Than the Interest Rates You Get
You're right in the middle of negotiating with the banks. You've been to five of them, and every one is doing everything it can to get you to take your mortgage with them in particular. It feels like a Turkish bazaar — and it really is one. You show the offer you got from bank A to the mortgage banker at bank B. Bank B immediately prints out a new mortgage mixture with a slightly better offer, shaving 0.05% off the first loan and 0.04% off the second.
This plays out over and over, and you're pleased with your newfound negotiating skills — talents you didn't even know you had. You figure you're well on your way to beating the system and landing an amazing mortgage that others can only dream of.
You're winning the battle and losing the war. Interest rates don't matter.
The psychological trap — interest rates don't necessarily tell you anything about a mortgage's quality
"A loan with a low interest rate is a cheap loan." If you ever get stuck in an especially dull dinner-party conversation that drifts onto mortgages, it's natural to start comparing whose rate came out lower and who got the better terms. We have good reason to think that's exactly what happens, because in our own conversations with people, it's far and away the most common question — meaning we treat the interest rate as the thing that stands in for the whole mortgage.
You probably won't hear a friend break it down like this: "Your fixed unlinked (KALATZ) rate is high, but you balanced it out with a short loan duration." That's just too involved an analysis, especially for a dinner party.
Why do we only care about interest rates? Because of "heuristics and biases"
Nobel Prize winner in Economics (1978) Herbert Simon defined the term "bounded rationality". Simply put, Simon argued that it is hard for us to solve complex problems because of our limitations as human beings. Given a challenging problem, we have little time to process all the information needed to solve it. Moreover, our mental capacity to process that information is limited.
In fact, Simon was the first to argue, contrary to the prevailing view at the time, that we are incapable of solving problems optimally because it is simply too hard and complicated. Thanks to this thesis, Richard Thaler credits Simon, in his book "Misbehaving," with laying the cornerstone of the field of behavioral economics.
Heuristics are mental shortcuts the brain uses to make quick decisions, and biases are the systematic errors those shortcuts produce — for example, the tendency to over-weight information that's readily available to us, or to judge how likely something is by how easily we can picture it.
Daniel Kahneman and Amos Tversky were Israeli psychologists who, in the 1970s, mapped dozens of heuristics and biases and proved that human beings deviate in a consistent and predictable way from the rational model of decision-making. Their work laid the foundations of behavioral economics, and Kahneman received the Nobel Prize in Economics for it in 2002 (Tversky died in 1996 and did not receive the prize, which is not awarded posthumously).
Example: Is Steve the librarian or the farmer?
Let's illustrate with an example taken directly from the Tversky and Kahneman paper:
"Steve is very shy and withdrawn, invariably helpful, but with little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail. Is it more likely that Steve is a librarian or a farmer?"
The resemblance between Steve's character and the typical librarian is clear and obvious. Steve must be a librarian, right? If that is your answer, you are wrong.
In the United States there are more than twenty farmers for every librarian. Since there are so many more farmers, the odds that Steve is a farmer are higher. And surely there are plenty of "meek and tidy" types out there growing our corn right now.
That was an example of the simplifying heuristic. The vast majority of us didn't know the answer to the librarian/farmer question. We couldn't weigh every aspect of the problem, so we "substituted" an easier one for it — we asked which of the two professions better fits Steve's character.
The connection to our mortgage
Yoni and Michal are a (fictional) married couple who need to borrow one million NIS from the bank to purchase their home. The bank offered them two different proposals. In both, the initial monthly payment is 5,102 NIS.
First offer - monthly payment of ₪5,102
| Loan track | Duration (years) | Interest rate | Loan amount | Monthly payment |
|---|---|---|---|---|
| Fixed unlinked (KALATZ) | 20 | 3.8% | ₪ 334,000 | ₪ 1,988.95 |
| Prime-linked | 20 | 1.25% | ₪ 333,000 | ₪ 1,568.88 |
| Variable CPI-linked every five years | 25 | 2.8% | ₪ 333,000 | ₪ 1,544.70 |
| Total | ₪ 1,000,000 | ₪ 5,102.53 | ||
Second offer - also a monthly payment of ₪5,102
| Loan track | Duration (years) | Interest rate | Loan amount | Monthly payment |
|---|---|---|---|---|
| Fixed unlinked (KALATZ) | 20 | 3.87% | ₪ 334,000 | ₪ 2,001.17 |
| Prime-linked | 23 | 1.325% | ₪ 333,000 | ₪ 1,400.35 |
| Variable CPI-linked every five years | 22 | 2.86% | ₪ 333,000 | ₪ 1,700.98 |
| Total | ₪ 1,000,000 | ₪ 5,102.5 | ||
- Note that the loan tracks are identical in both offers. Also, the total amount allocated to each loan is completely identical!
- In the second offer, the interest rates are higher on all tracks by at least 0.06% compared with the first offer.
- If the interest rates do not represent the current market - disregard that; our purpose here is only to illustrate a principle with an example.
- Ignore changes in the prime rate and inflation. Assume there will be no inflation and no change in the prime rate in the coming years.
Which offer is better? Which should they choose?
Since both offers carry the same monthly payment, the only deciding factor is which offer has lower total interest payments.
What should Yoni and Michal choose? Try to reach a decision without using a calculator. If you don't know, that's perfectly fine — this topic is never taught in high school and no one is expected to know the answer off-hand.
Why did most of us think the first mortgage offer was better? Because this problem is too complicated, so we decided to simplify it. We focus our effort on trying to answer an easier question instead, and assume that the answer to the hard question will be the same as the answer to the easy question.
How do you solve a hard problem? You try to turn it into an easy one
To set the stage for the easy question, we fall back on simple arithmetic: with loans, a lower interest rate is cheaper. So we reach for the following wrong rule of thumb:
"A mortgage with lower interest rates is a cheaper mortgage."
This rule is correct when we take a loan that has only a single track. A car loan is a good example of a situation where this rule is very useful. By contrast, this rule is not correct when several loans are bundled together into one mortgage mixture.
How can a mortgage mixture with higher interest rates be cheaper? Because the loan duration affects its cost far more than its interest rates do.
Let's overstate it a bit to drive the point home — interest rates don't matter!
In a loan based on an annuity amortization schedule (Spitzer), if the loan duration is shorter, the pace of debt repayment is faster. Therefore, even if the loan's interest rate is higher, it is "applied" to a smaller outstanding balance.
What can you do?
Stop comparing mortgages by their interest rates. The mortgage rate is no measure of its quality. Mortgage bankers know people are starting to catch on to this, so they dazzle you with low interest rates that paper over a weak mortgage mixture, all to lure you into signing with them.
If you're offered a single loan at a near-zero rate, don't be dazzled by it. That's just one loan in a whole mortgage mixture! Always look at the mixture as a whole.
If you absolutely must talk about interest rates, do it alongside the loan duration, because only then is the picture of the loan's cost complete. The best way to compare different mortgage offers is by their market spread or their internal rate of return (IRR).
Good luck!