Taking on a mortgage

April 27, 2008 BY danariely

Sumi (my lovely wife) and I are currently house hunting. So we’ve been thinking about how difficult it is to calculate the optimal amount of money we should spend on a house. And how much of it should we take as a mortgage? To work this out, we need to take into account our current income, our expected future income, our predictions for the stock market and the housing market, and the interest rate of mortgages today and in the future. On top of that, we need to consider the amount of happiness different houses will provide us, and how that level of happiness measures up against the lifetime costs of these homes. 41 years of education between us does not seem to be enough to figure this out.

Standard economics assumes that we’ll always act in a way that serves our best interest. But it’s very difficult for us to calculate what’s in our best interest in terms of home purchasing. So, how can we be sure that our decisions will maximize our welfare? Calculating the right amount we should be spending and borrowing is so complex. And banks don’t do much these days to help us determine how much we should borrow.

So what did we do? We realized that figuring this out rationally was a lost cause. We relied on some simple but arbitrary factors. We picked a neighborhood that we liked a lot. We found the house that we liked the most within this neighborhood. Then we offered to buy it for $10,000 less than the asking price. I think that the owners of that house could have asked for $100,000 more or $100,000 less than their current price and we would have still offered them just a bit less than their asking price.

The problem is that we just have no idea how much this house is worth to us. We don’t know how to translate the pleasure we expect to get from it to the amount we are willing to pay for it. And if the sellers accept our offer, we still have to decide how much to borrow and get a mortgage.

This ordeal is clearly not a rational decision-making process…but at least we are now closer to having a home.