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Choosing Between Fixed and Adjustable Rate Mortgages

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  • Paiella, Monica
  • Pozzolo, Alberto Franco

    ()

Abstract

This paper estimates the determinants of households’ choice between fixed rate (FRM) and adjustable rate mortgage (ARM) contracts, using the Bank of Italy’s Survey of Household Income and Wealth. Contrary to the predictions of the theoretical literature, the analysis shows that most household characteristics proxying for exposure to other (non-mortgagerelated) risks and for individual risk aversion are irrelevant for the choice. This, in turn, crucially depends on the relative price of the mortgages and on whether the household is liquidity constrained. Liquidity constrained households find ARMs particularly attractive because their initial payments are generally lowest, ceteris paribus. This is so despite some evidence that the premium that lenders charge over their cost of funds is substantially higher on ARMs than on FRMs. Taken together, the evidence suggests that ARM holders do not fully take into account the risk of a rise of the reference interest rates. On the other hand, lenders price quite expensively this risk and borrowers end up paying a high price for the benefit of low initial payments.

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File URL: http://web.unimol.it/progetti/repec/mol/ecsdps/ESDP07033.pdf
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Bibliographic Info

Paper provided by University of Molise, Dept. EGSeI in its series Economics & Statistics Discussion Papers with number esdp07033.

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Length: 41 pages
Date of creation: 10 Apr 2007
Date of revision:
Handle: RePEc:mol:ecsdps:esdp07033

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Keywords: home purchase finance; adjustable rate mortgages; fixed rate mortgages.;

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References

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  1. Tullio Jappelli & Luigi Pistaferri, 2002. "Incentives to Borrow and the Demand for Mortgage Debt: An Analysis of Tax Reforms," CSEF Working Papers, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy 90, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  2. Luigi Guiso & Tullio Jappelli, 2000. "Household Portfolios in Italy," CSEF Working Papers, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy 43, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  3. Blundell, Richard & Costa Dias, Monica, 2008. "Alternative Approaches to Evaluation in Empirical Microeconomics," IZA Discussion Papers 3800, Institute for the Study of Labor (IZA).
  4. John Campbell & Joao F. Cocco, 2002. "Household Risk Management and Optimal Mortgage Choice," Computing in Economics and Finance 2002, Society for Computational Economics 47, Society for Computational Economics.
  5. Jappelli, Tullio & Pistaferri, Luigi, 1997. "Using Subjective Income Expectations to Test for Excess Sensitivity of Consumption to Predicted Income Growth," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1617, C.E.P.R. Discussion Papers.
  6. Marjorie Flavin & Takashi Yamashita, 2002. "Owner-Occupied Housing and the Composition of the Household Portfolio," American Economic Review, American Economic Association, American Economic Association, vol. 92(1), pages 345-362, March.
  7. Daniela FABBRI & Mario PADULA, 2003. "Does Poor Legal Enforcement Make Households Credit-Constrained?," FAME Research Paper Series, International Center for Financial Asset Management and Engineering rp81, International Center for Financial Asset Management and Engineering.
  8. Loriana Pelizzon & Guglielmo Weber, 2006. "Are Household Portfolios Efficient? An Analysis Conditional on Housing," Working Papers 2006_55, Department of Economics, University of Venice "Ca' Foscari".
  9. Engelhardt, Gary V., 1996. "House prices and home owner saving behavior," Regional Science and Urban Economics, Elsevier, Elsevier, vol. 26(3-4), pages 313-336, June.
  10. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Daniele, 1994. "Income Risk, Borrowing Constraints and Portfolio Choice," CEPR Discussion Papers, C.E.P.R. Discussion Papers 888, C.E.P.R. Discussion Papers.
  11. Erich Battistin & Raffaele Miniaci & Guglielmo Weber, 2003. "What do we learn from recall consumption data?," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 466, Bank of Italy, Economic Research and International Relations Area.
  12. James M. Poterba, 2001. "Taxation and Portfolio Structure: Issues and Implications," NBER Working Papers 8223, National Bureau of Economic Research, Inc.
  13. Brueckner, Jan K & Follain, James R, 1988. "The Rise and Fall of the ARM: An Econometric Analysis of Mortgage Choice," The Review of Economics and Statistics, MIT Press, vol. 70(1), pages 93-102, February.
  14. Silvia Magri, 2002. "Italian households' debt: determinants of demand and supply," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 454, Bank of Italy, Economic Research and International Relations Area.
  15. Jonathan Skinner, 1993. "Is Housing Wealth a Sideshow?," NBER Working Papers 4552, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Luigi Guiso & Paolo Sodini, 2012. "Household Finance. An Emerging Field," EIEF Working Papers Series 1204, Einaudi Institute for Economics and Finance (EIEF), revised Mar 2012.
  2. Beer, Christian & Ongena, Steven & Peter, Marcel, 2010. "Borrowing in foreign currency: Austrian households as carry traders," Journal of Banking & Finance, Elsevier, Elsevier, vol. 34(9), pages 2198-2211, September.
  3. Roberto Felici & Elisabetta Manzoli & Raffaella Pico, 2012. "Crisis and Italian households: a microeconomic analysis of mortgage contracts," Questioni di Economia e Finanza (Occasional Papers), Bank of Italy, Economic Research and International Relations Area 125, Bank of Italy, Economic Research and International Relations Area.

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