The Psychology of Subprime Mortgages

Jonah Lehrer in The Frontal Cortex:

Img_9753The shit is hitting the fan: all those sub-prime mortgages given out so recklessly over the past two years are getting their interest rates re-adjusted. And that, of course, is when the foreclosures begin.

By most measures, sub-prime loans are a bad idea. Look, for example, at the popular 2/28 loan, which consists of a low, fixed-interest rate for the first two years and a much higher, adjustable rate for the next twenty-eight. Most people taking out a 2/28 loan can’t afford the higher interest rates that will hit later on. It’s not unusual for interest payments on a 2/28 loan to double within four years. (That’s why you’re seeing such high foreclosure rates in the sub-prime market.)

So why do people take out sub-prime loans? Don’t they realize that they won’t be able to afford the ensuing 28 years of mortgage payments? I think a big part of the reason sub-prime loans remain so seductive, even when the financial terms are so atrocious, is that they take advantage of a dangerous flaw built into our brain. This flaw is rooted in our emotional brain, which tends to overvalue immediate gains (like a new house) at the expense of future costs (high interest rates). Our feelings are thrilled by the prospect of a new home, but can’t really grapple with the long-term fiscal consequences of the decision. Our impulsivity encounters little resistance, and so we sign on the bottom line. We want the house. We’ll figure out how to pay for it later.

The best evidence for this idea comes from the lab of Jonathan Cohen.

More here.