Taking a step back for a broader view when making important financial decisions can help avoid several thinking traps. Six tips for current or prospective homeowners are explained below.
1. Imagine you don’t own it When people own an item, they tend to value it more. This endowment effect has been demonstrated for small items, such as coffee cups, and may make a much bigger financial impact if it sways choices about buying or selling a home. As explained above, why not try to reduce the emotion involved by imagining the property is someone else’s?
2. What’s gone is gone It can be difficult to decide to sell an investment that has lost money – even if it makes financial sense to do so. One reason is the sunk cost trap, where people think more about money already spent than future potential gains or losses. Economist Chris Dillow blogs about this for eZonomics, saying: “We should recognise that past losses – on horses, houses or shares – can be considered irrelevant. What matters more are prospective gains and losses, not past ones.”
3. Confidence versus reality The UK’s Financial Conduct Authority wrote in an occasional paper that overconfidence may tempt people to borrow too much when taking out a mortgage. Having too much debt can cause a lot of problems. One way to counter overconfidence might be to “stress test” personal finances. For example, consider how repayments may hold up if there is an interest rate hike, household income falls, or another financial emergency. Include typical homeowner costs such as repairs, insurance and taxes – easy items for first-time buyers to forget.
4. “Do I want to pay more?” It may sound odd but sometimes paying more can save money. The 2013 ING International Survey on Homes and Mortgages found that a vast majority of people in Europe who found it easy to pay their mortgages were not paying them back as quickly as they could. At times of low interest rates especially, this can be a missed opportunity. Some homeowners might have good reasons not to pay more – particularly if struggling to make ends meet or if related fees are high. However, many people may simply be sticking with what they have always done – lulled into a sense of inertia.
5. Keep today’s news in perspective If news reports say house prices are rising, a prospective buyer might feel pushed to get in quick and buy now. But it can pay to stop for a moment and ask if availability bias is having an impact. Fresh news typically stands out more when making a decision – something more important may be missed as a result. In the house price example, looking at price movements over a much longer period of time, perhaps several years or decades, can put today’s news into perspective. Remember: prices of individual homes can be much more volatile than the house price indices suggest, as Dillow blogs.
6. Beware the neighbours There’s a lot to like about living in a street with helpful neighbours. What might not seem so obvious is that their habits may rub off on you. A famous Dutch study suggests that if a neighbour wins a new car, others in the street are more likely to buy one too. Known as a peer effect – or keeping up with the Joneses – it means buying in a fancy area can end up costing more than expected.