Three staff member of the Federal
Reserve Bank of San Francisco have published, on the Bank's website, results of
a study about what drives the mortgage choices of borrowers. The three, Fred Furlong, David Lang, and
Yelena Takhtamanova looked at the question of whether lower-rated borrowers
paid less attention to loan pricing and interest-rate-related factors because house
prices were rising rapidly.
They developed a model to account
for the factors that influence mortgage choice.
Earlier research has found that mortgage pricing and other
interest-rate-related fundamentals are key but they also looked at housing
market conditions and borrower characteristics, such as degree of financial
constraint, attitudes towards risk, and mobility. Research has shown that financially
constrained borrowers, or those with lower credit ratings tend to favor
adjustable rate mortgages (ARMs) as do homebuyers who expect to only stay in a
house a short time because ARMs have lower introductory interest rates.
Fixed-rate mortgages (FRM) initially
tend to have higher interest rates than ARMs because they are tied to long-term
interest rates which include a term premium to compensate investors for tying
up their money longer. Both FRM and ARM rates include lender margins, that is,
mark-ups reflecting general credit supply conditions, regional economic and
housing market conditions, and individual borrower characteristics. Relative
shifts in FRM and ARM margins can affect financing choices.
How much risk borrowers are willing
to accept also can influence mortgage choice. Borrower risk tolerance can
affect sensitivity to loan pricing, income volatility, and affordability in
choosing mortgages. Borrowers with low credit ratings may be less sensitive to
risk, for instance, because of lower cost of default. Research shows that more
risk-averse borrowers tend to favor FRMs or option ARMs because they prefer to
avoid the risk of future sharp rate increases possible with volatile
Thus, a mortgage choice model should
include measures of the term premium, expected short-term interest rates over
time, FRM and ARM margins, and interest rate volatility. In general, borrower
preference for basic ARMs should increase as the term premium, expected
short-term interest rates, and FRM margins rise, and ARM margins and interest
rate volatility fall. In other words, the more affordable ARMs become by comparison, the more they're favored. No surprises here...
Research also shows that the faster
house prices are rising, the greater the probability that homebuyers will
choose ARMs. In addition, rising house prices can affect the importance of
interest-rate-related fundamentals when borrowers choose financing.
The researchers say that one view is
that the housing boom was a bubble in which financing decisions for some
borrowers were divorced from traditional fundamentals while another is that
borrowers paid less attention to fundamentals during the housing boom, but that
such a shift is consistent with rational decision-making models, given
expectations of further house price appreciation. According to this view, with
little or no change in house prices, homeowner decisions about moving or
terminating a mortgage would generally reflect life-cycle events, such as
illness, retirement, and job changes.
Rapid house price gains might change
that. During the boom homeowners
expected to gain home equity as prices rose, allowing them to refinance even if
they didn't plan to move or expected to flip houses soon after buying them. Such short-term mortgages might make ARMs more
attractive and reduce borrower sensitivity to interest-rate-related
fundamentals. In other words, they didn't care as much about the riskier nature of the loans because they planned on being out of them relatively quickly.
Finally, studies suggest that
borrower financial literacy may affect mortgage choice. Borrowers who choose ARMs appear more likely
to underestimate or not understand how changes in interest rates would affect
their loans. Hence, systematic differences in levels of financial literacy
among borrowers at different risk levels could affect sensitivity to
The study's model of mortgage choice
allows for an examination of how these factors affected the decisions of
borrowers at different credit risk levels. The authors studied a sample of
about 9 million first-lien mortgages originated between January 1, 2000, and
December 31, 2007 allowing for three mortgage choices: FRMs, basic ARMs, and
option ARMs. Key model determinants are
FRM and ARM margins, the 10-year Treasury term premium, expectations for
short-term interest rates over time, and interest rate volatility. Controls
included loan-to-value ratios, borrower credit risk, the two-year average
change in house prices, and a measure of house price volatility. Finally, credit
risk groups were defined by FICO scores: low, 660 or below, high, 760 or above,
and medium 661 to 759.
The model allows the impact of
interest-rate-related fundamentals to change as house prices rise. The
estimates show that rising house prices have a sizable influence on the effect
these fundamentals have on mortgage choice. The size of this effect differs
according to borrower credit ratings.
Figure 1 shows the impact of margins
and term premiums on the probability of borrowers choosing an ARM. The green bars indicate those factor's
marginal effects if house prices are static.
A higher margin makes ARMs less attractive so the marginal effects are
negative. The low FICO group shows a
greater effect indicating they are more sensitive to ARM mortgage pricing than
the higher FICO cohort. "Specifically,
if house prices were flat, a 0.8 percentage point increase in the ARM margin
would reduce the probability of low FICO borrowers choosing an ARM 13
percentage points and high FICO borrowers 8 percentage points. It is useful to
compare this with the ARM share of mortgage originations, shown in Figure 2,
which peaked at 50%."
The two year average house price
appreciation was 16 percent. The red
bars show the offsetting effects of this with a reduction of one-third in the
ARM margin to 8 percentage points for low FICO borrowers and 5 points for high
FICO borrowers. Similarly, house price
appreciation reduces the impact of increases in the FRM margin and term premium
on mortgage choice. Thus, even accounting for the influence of house price
gains, lower FICO borrowers generally were at least as sensitive, if not more
sensitive, to fundamentals as the high FICO borrowers.
But, if low and high FICO borrowers
gave similar consideration to interest- rate-related fundamentals, why were low
FICO borrowers more likely to select ARMs during the housing boom? Credit risk measures, including FICO scores
and lender designation of borrowers as subprime, explain most of the difference
in ARM shares. The authors considered whether borrowers would have made the
same mortgage choice if, all else equal, they had different credit ratings. In
Figure 3, for each month in the sample, they replaced the actual FICO score and
subprime designation of each borrower in the low FICO group with the average
score and subprime share of the high FICO group. The results of this
hypothetical exercise, shown by the green line, suggest that the low FICO
group's ARM share would have been closer to that of the high FICO group had
their credit risk been similar.
One could interpret the results as credit
risk measures being associated with borrower level of financial sophistication
or the findings could reflect economic decisions related to risk aversion,
credit constraints, or differences in how quickly borrowers expect to
refinance. The authors conclude rising
prices during the housing boom muted the influence of interest rate
fundamentals on borrower mortgage choice, especially among borrowers with lower
credit ratings. But when house prices
rose rapidly, those borrowers responded at least as strongly as higher-rated
borrowers to changes in fundamentals. "This suggests," they say, "that the
greater propensity of low FICO borrowers to choose ARMs is more consistent with
mortgage choice reflecting economic considerations rather than lack of
financial sophistication among low FICO borrowers."