Choosing Between Fixed and Adjustable Rate Mortgages

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Choosing Between Fixed and Adjustable Rate Mortgages

Author Info

Paiella, Monica
Pozzolo, Alberto Franco ()

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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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Publisher Info
Paper provided by University of Molise, Dept. SEGeS 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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Find related papers by JEL classification:
D10 - Microeconomics - - Household Behavior - - - General
G1 - Financial Economics - - General Financial Markets
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

This paper has been announced in the following NEP Reports:

NEP-ALL-2007-05-12 (All new papers)
NEP-BAN-2007-05-12 (Banking)
NEP-URE-2007-05-12 (Urban & Real Estate Economics)

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