Does Refi Advertising Help or Hurt Borrowers and Lenders?

"Mortgage borrowers frequently make costly refinancing mistakes by either refinancing when they should wait, or by waiting when they should refinance."  That is the working premise of a paper published as part of the Federal Reserve's Finance and Economics Discussion Series. 

The paper, by Serafin Grundl and You Suk Kim, is titled "Consumer Mistakes and Advertising: The Case of Mortgage Refinancing."  Consumers, the authors say, tend to make mistakes and companies engage in various activities that can encourage mistakes, exploiting the biases of consumers to sell them overpriced products or those they don't need, or conversely prevent mistakes by encouraging beneficial actions.  Policies that restrict or regulate advertising can help the consumer, but where firms have an incentive to help consumers recognize products they do need, such restrictions would be harmful.

The authors attempt to estimate the effects of advertising on consumer mistakes and quantify the resulting net effect of consumer welfare.  Mortgage refinancing is an area where potentially costly refinancing mistakes include refinancing a fixed rate mortgage at a rate not low enough to cover the refinancing costs; refinancing prematurely, i.e. before that trigger point is reached, or refinancing too late or not at all.  It is also an arena where the product is not consumed, there are no prestige effects in the advertising, and an objective measure of benefits is available, the net present value of mortgage payments.

Advertising can call attention to the benefits when borrowers who should refi are not paying attention to rates, but can also be deceptive, i.e., highlighting the savings without explaining they result in part by refinancing into a longer loan term. Such ads might convince borrowers to refinance prematurely.

The net effect of advertising on borrower welfare depends on three things:

• Differential responsiveness, i.e. whether borrowers who should refinance are more responsive to advertising, than those who shouldn't.
• Targeting and intensity of advertising, which determines whether and how much advertisers target borrowers who should refinance.
• Borrower composition, i.e. how many borrowers should refinance and how many should wait, and how much can they gain or lose if they decide to refinance.

The authors say the data needed to set up the type of study does not exist so they assembled a borrower-level data set that combines exposure to direct mail refinancing ads with borrowers' subsequent refinancing decision. The final sample consists of 12,435 borrower-month pairs from 2009 to 2015. All borrowers have a fixed-rate mortgage.

Borrowers received an average of 0.23 refinance ads by direct-mail a month, approximately one piece every four months.  The sample contained 10,941 borrowers who should wait and only 1,494 borrowers who should refinance and those who should refinance received 50% more advertising than those who should wait, which suggests that advertisers are targeting those borrowers. Still, about 83% of all refi ads are sent to borrowers who should wait. Specialized mortgage firms, as opposed to depository institutions, accounted for approximately 50 percent of the total ads.

The authors found the probability of refinancing increases by approximately 4 percentage points or roughly 25 percent among borrowers who should refinance over the three quarters after they receive an ad. However, advertising has no significant effect on the larger group of borrowers who should wait. These estimates suggest that refi advertising helps borrowers who should refinance without hurting the others.

To quantify the effect of refi advertising on borrower welfare, the authors used the expected net present value of mortgage payments. Even though the borrower composition is such that the average borrower would lose approximately $500 from the costs of refinancing, the average monthly exposure of 0.23 refi ads reduces the net present value of mortgage payments by $9 - $13. This is due to differential responsiveness and targeting, i.e. borrowers who should refinance are more responsive to advertising and more likely to receive advertising. Without differential responsiveness, i.e. if all borrowers were equally responsive to advertising, the benefit would decrease to $0-$0.5.  If advertising is not targeted and all borrowers receive the average amount of it, the benefit would decrease to $4-$11. An improved targeting policy that redirects all advertising would increase the gain in consumer welfare to $47 and lead to a fivefold increase in the responsiveness of the average ad recipient.

The authors also conducted a counterfactual experiment to investigate the potential benefits of improved targeting. If all advertising is redirected only to borrowers who should refinance, leaving the total amount of advertising (advertising intensity) unchanged, it would increase the benefit of advertising from $9-$13 to $45-$50. Therefore, advertisers would likely also be better off with improved targeting.

This result suggests that advertising is potentially beneficial for borrowers. First, even though most borrowers should not refinance, an advertising ban for refi loans would harm borrowers overall.   The estimated heterogeneous effects of advertising will help to mitigate mistakes of those borrower who fail to take advantage of low interest rates. Differential responsiveness means that, at the same time, advertising is unlikely to exacerbate mistakes of premature refinancing for those who would not benefit from refinancing.

The recipients of refi ads appear to respond more to the informative aspects of refi ads than to the deceptive aspects. Inattentive borrowers fail to take advantage of lower mortgage rates because do not consider the possibility of refinancing. The authors even go so far as to say that even deceptive advertising increases borrower well-being as borrowers who should refinance are more easily deceived than those who should wait.

Differential responsiveness is just one of the factors that determine the net effect of advertising on borrower welfare. It also depends on targeting and the composition of borrowers. Policies that allow advertisers to better target borrowers who should refinance could benefit borrowers and advertisers. However, the benefits of such a policy would have to be weighed against the privacy concern of borrowers.  The findings suggest that policies that are aimed at protecting the privacy of consumers can make consumers worse off if they make targeting more difficult.

These findings raise the question why lenders don't improve targeting to reach more borrowers who should refinance, given that they are also more responsive. First, better targeting is expensive. By law, lenders are not allowed to have direct access to a borrower's credit file and can only purchase information about borrowers satisfying certain criteria from a credit bureau.  The cost of acquiring such information might be higher than the results warrant.

Targeting might also increase positive spillover - that is a borrower who should refinance, if informed by an ad about the cost savings from refinancing, might do so but with another lender.  This positive spillover decreases the return to advertising from a lender's perspective and thus increases to relative cost of targeting. 

The authors say their findings suggest that policy makers should facilitate targeting of refi advertising to borrowers with more to gain from refinancing rather than restricting those ads. For example, a policy that makes it easier for lenders to have access to a credit file from a credit bureau might lead to better targeting. Another possibility is for government-sponsored enterprises such as Freddie Mac and Fannie Mae to make more accessible information about borrowers in their files, who could gain significantly from refinancing. Moreover, although there is a growing concern about privacy and collection of information about consumer, the findings suggest that limiting an advertiser's ability to target consumers can be costly.

The authors summarize their findings thusly: "(They) highlight that firms do not only have an incentive to exploit the behavioral biases of consumers, but also to prevent consumer mistakes if they fail to buy products they need. The findings have implications for the regulation of advertising. First, advertising bans can be harmful for consumers, even if most consumers would be harmed by buying the product. Second, our results suggest that targeting of refi advertising should be facilitated as it would help borrowers and likely also advertisers. The benefits of such a policy, however, would have to be weighed against the privacy concerns of borrowers."