Measuring Financial Sophistication: A Novel Approach Using Mortgage Bunching Effect as a Proxy

This paper proposes a novel, behaviorally grounded proxy for household financial sophistication by analyzing mortgage bunching behavior at the Federal Housing Finance Agency’s (FHFA) conforming loan limit (CLL). The CLL creates a sharp discontinuity in mortgage interest rates between conforming and jumbo loans, which rational, financially sophisticated borrowers should exploit by adjusting their loan amount to stay below the threshold. Using a national loan-level dataset from CoreLogic and adapting notch-based bunching estimation techniques, this paper measures the extent to which households respond to this incentive and interpret the normalized bunching mass as a revealed-preference indicator of financial sophistication. The paper validates this proxy by demonstrating that borrowers with higher FICO scores and those who refinance—commonly considered more sophisticated—exhibit significantly greater bunching behavior. Furthermore, it estimates the interest rate semi-elasticity of mortgage demand and control for liquidity constraints to isolate the role of information and optimization ability. This paper finds that costly suboptimal borrowing is widespread, with non-bunching behavior imposing substantial financial losses on households. The approach provides a scalable, data-driven framework for evaluating household decision-making in housing finance and has broad implications for FHFA policy design, consumer protection efforts, and the targeting of financial literacy initiatives.