Through good fortune and diligent savings, we have some money left over each month after paying off the bills and funding the 401K. Our mortgage rate is currently 5.125%. Investing in index funds will possibly offer a return of over 8%, over the long term. Rationally, it makes more financial sense to stash the additional money we have in a well-chosen index fund. But month after month, we apply the money to the principal of our mortgage loan. It’s not like we are this irrational all the time – while paying off our debt, we chose to pay down the highest interest loan first, instead of Dave Ramsey’s feel-good theory of paying the lowest balance loan first and I dabble in credit card arbitrage quite a bit. So, why are we so irrational when it comes to mortgage?
I have been mulling over this question for a long time now. I think I may finally be able to explain it using some of the behavioral economics concepts that I am reading. Here is one of the example “stories” from the book Why smart people make big money mistakes and how to correct them. Pay close attention and answer honestly.
Imagine that you are a commander in the army, threatened by a superior enemy force. Your staff says your soldiers will be caught in an ambush in which six hundred of them will die unless you lead them to safety by one of the two available routes. If you take route A, two hundred soldiers will be saved. If you take route B, there’s a one-third chance that six hundred will be saved and a two-thirds chance that none will be saved. Which route should you take?
Have you decided? If yes, then let me repeat the question, this time phrased a bit differently. Read the question carefully again, and answer honestly. Don’t let your previous answer affect you – just choose an answer that pops at the top of your head when you finish reading the question.
Imagine that you are once again a commander in the army, threatened by a superior enemy force. Once again, your staff tells you that if you take route A, four hundred soldiers will die. If you take route B, there’s a one-third chance that no soldiers will die and a two-thirds chance that six hundred soldiers will perish. Which route should you choose?
The book says that, according to research conducted by two Israeli psychologists, it is more than likely that you chose route A in the first scenario and route B in the second scenario. Even though it was the exact same choice, the first question was framed to highlight a sure saving of two hundred lives, which makes it a choice hard to pass up for most people. On the other hand, the second question highlights the guaranteed loss of four hundred lives. When presented with a choice between a huge loss and a gamble with the possibility of saving all lives, most people are willing to take the chance rather than commit to a huge loss.
The authors explain that this is the same with our financial decisions. Quoting from the book – "In financial matters this phenomenon results in a willingness to take more risk if it means avoiding a sure loss and to be more conservative when given the opportunity to lock in a sure gain". I think that nails it!
Let’s apply it to our decision about the mortgage. I have mentioned before that we had made some bad decisions early on and were in considerable amount of debt before. It left a very bad feeling in our mouth. We worked very hard to get rid of it. So when we took on a huge debt like mortgage, and now have some money to spare, we frame the decision as the choice of whether to lock in the *guarantee* that we will reduce our debt, or take the chance that we *might* get better returns by investing it elsewhere. When the decision is framed that way, the choice seems to be to go for the guaranteed reduction in debt. While responding to a comment in an earlier post, even before I started thinking of this from a behavioral economics perspective, I had said, "Stretching the mortgage longer will make sense only if you can guarantee that the interest rate on your investment will be higher than your mortgage rate. Paying the minimum on mortgage and investing the rest in stocks/mutual funds etc can provide the higher rate of return but there is no guarantee. If the stock market crashes, you have neither the equity on the house, nor the stocks. With a huge loan like mortgage, I would rather err on the conservative side." That pretty much says it all.
Now think of someone who does not have a bad experience with debt but has a bad experience with a lost opportunity. Or someone who has had the sweet taste of making huge returns on a successful investment. The scenario looks different. They look it as the choice of the huge opportunity cost of lost interest versus a chance to earn good interest. In which case they choose to not pay off the mortgage, but rather invest the money in ventures that earn better interest.
That said, is one choice better than the other? Well, if we think of it from a purely rational point of view, our choice to pay-off the mortgage is the one that is wrong. But from a psychological perspective, the more conservative approach offers us more peace of mind. We are more relaxed about where we are going financially. Also, since we have a prior run in with debt and have a deep seated hatred towards it, I believe we work harder at scrimping and saving when we aim to get rid of debt. This gives us a better chance to succeed at our financial goals. In other words, some times what is right rationally, may not be really *right* if you are not psychologically prepared for it. So, one way or the other pick what's right for you and keep at it. As long as you are making progress - be it in reducing the mortgage or increasing your wealth through smart investments - you are doing good.
P.S.: The book that the example stories came from - Why smart people make big money mistakes and how to correct them – is really nice. If you had an "aha" moment when you read the stories, I definitely recommend that book to you. It's chock full of example stories like these, to explain the different concepts in behavioral economics.
Update 05/09/07: I mailed JLP @ All Financial Matters about this post and he put up an article about it on his blog. There is an interesting discussion going on there which you might want to check out, if this topic interests you.
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