The ‘Price discrimination and mortgage choice’ report showed customers rarely picked the cheapest mortgage but found cost implications were usually relatively small because of the options given.
While the consequences were not dire, BoE found borrowers who had fewer options, or who were less able to identify or avoid expensive options, were likely to experience price discrimination from lenders.
These customers tended to be those who borrow large amounts relative to their income and the value of their home.
The report looked at the options borrowers had within a single bank – where lenders could control which offerings customers saw, and could potentially discriminate based on customer characteristics.
It also examined cross-bank options, to determine the benefits of shopping around as well as the role of competition.
The sample was based on 2009 to 2014. The median borrower in the sample had taken out a mortgage of £136,000 and made a down payment of 20 per cent. The median income was £37,000 after tax.
First-time buyers made up 40 per cent of the sample which BoE said was because older borrowers would be re-financing at lower LTVs than they were analysing.
The report analysed that the typical customer has more than 15 options at a single bank, and more than 70 across banks.
Just five per cent chose the cheapest deal offered by their bank and most choices did not save or cost a large amount of money.
For 85 per cent of possible choices, customers would neither save more than 0.5 per cent of their monthly income nor would it cost more than one per cent. Across banks, two-thirds of choices are within the same range of costs and savings.
While customers do not always choose well, the role of competition keeps banks in line and protects customers.
This is because banks categorise customers by sophisticated borrowers who shop around and choose the best deal, and randomised borrowers. Thos who pick a random choice do so either because they find it too costly to shop around, are unable to, or are unaware of alternative options.
As banks want to attract both kinds of people, they limit the number of expensive options to prevent more sophisticated customers from going elsewhere. They also offer products with similar prices, meaning borrowers will not lose a large amount of money even if they do not pick well.
“We find that customers who are borrowing a lot relative to their income and home value are given worse choice sets. These customers are more likely to resemble the randomisers than those who are not borrowing much relative to their home or income.
“As a result, these customers are the type that lenders would like to exploit, in order to profit from them either because of their lack of sophistication or because of their possible lack of choices. The market equilibrium will mean that these customers are more likely to wind up with expensive mortgages,” the report said.
Within banks, 2.3 per cent of borrowers make choices that cost them more than 2.5 per cent of their income, and across banks, this figure is 6.7 per cent.
BoE defined a “big mistake,” as an option that costs a borrower more than 2.5 per cent of their monthly household take home.
For the average borrower, this amounts to around £88 per month, which BoE said was “a meaningful amount of money,” given the net income of the typical customer on a salary of £37,000.
BoE concluded there were two reasons why a borrower would make a mistake with mortgage choice. Either they are choosing badly from the menu they are given, or they have a larger number of poor, expensive options.
It found 87 per cent of people were faced with a menu that prevented big mistakes within their bank. Across banks, 42 per cent of borrowers did not face significantly costly choices. Again, this highlighted the role of competition amongst lenders.
As mortgage choice worsens, the likelihood of big mistakes rises, suggesting that customers make errors when banks make it easy for them to do so.
While legal constraints stop banks from offering borrowers mortgages based on race, gender or intelligence, the report found that loan to value (LTV) and loan to income (LTI) categorisations had an impact.
Borrowers with mortgages at 85 per cent LTV and above, with LTIs of at least 4, tended to have a higher chance of choosing “bad mistake,” mortgages.
BoE found this was consistent across banks.
High LTV and LTI customers were found to be nine per cent more likely to make a mistake within-bank, than one with a low LTV and LTI. This was also four times more likely than the overall average.
Even when they were not presented with a bad menu from their bank, a customer with high a LTV and LTI was still two per cent more likely to make a mistake than one with low LTV and LTI, suggesting such borrowers were generally worse at shopping around.
The report said: “Young people and first-time buyers are choosing the types of mortgage contracts where banks offer bad menus.”
How mistakes are made
Initial interest rate is the main driver for poor mortgage choice, the report said. Choosing a high rate increases the likelihood of a mistake by five per cent within a bank and 15 per cent across banks.
It found the choice of fees had close to zero impact on mistakes as they are generally not large enough to affect the mortgage cost.
However, customers who pick products with low fees are 20 per cent more likely to choose a mortgage with a high initial rate than those who go for a product with a high fee.
For fixed terms of two years, picking a low fee does not lead to mistakes but it can with longer fixed periods, the report found.
Roughly the same proportion of borrowers who choose poorly at their own bank do not make a mistake when a choice is given across banks. This happens where banks make picking in-house costly, but where the chosen mortgage is not that expensive compared to market-wide options.
Around one in 18 people do not select badly based on options within their bank, but they do choose an expensive mortgage compared to what is more widely available.
The report also said that customers who do not shop around are more likely to make mistakes. If borrowers focus on low fees rather than initial rates, they are more prone to making a bad choice.
It said: “There is some evidence that the expensive choices come from focusing more on fees associated with a loan instead of the promotional interest rate and not paying sufficient attention to the interest rate that prevails once an introductory, promotional interest rate expires.”
The report concluded: “The best predictor of when these big mistakes occur is whether the borrower has a relatively large number of expensive options in the menu they are facing. The variation in menus seems designed with price discrimination in mind.
“Banks try to make it easy for customers who might be prone to select badly to do so, without scaring away other borrowers that they expect have the ability to shop at other lenders. This competitive pressure seems to explain why most borrowers can find a reasonable mortgage even if they do not pick particularly well.”