The housing boom and its accompanying
price appreciation significantly distorted buyer choices about mortgage
financing according to an Economic Letter
authored by two economists with the Federal Reserve Bank of San Francisco. This distortion was most notable in those
markets with the highest house price appreciation where the authors noted price
gains directly influenced mortgage choices.
Fred Furlong, a group vice president in the Economic Research Department and
Takhtamanova, an economist in the Economic
Research and Public Information Departments at the San Francisco bank found
that, in high-appreciation markets, the pace of home price increases was
strongly linked to the popularity of adjustable rate mortgages but in other
markets house prices had no impact on mortgage choice. The higher price appreciation also muted the
influence of fundamental drivers of mortgage choice such as mortgage interest
rate margins, perhaps because homebuyers in those markets expected to hold
their loans only briefly before refinancing.
mortgages (FRMs) have been the most popular loans in the U.S. but Figure 1 shows
that the adjustable rate mortgage (ARM) share of mortgages as reported by both
Freddie Mac and the LPS Applied Analytics database became more popular during
the housing boom and especially during the years of greatest price appreciation
which the authors defined as a two-year change in the CoreLogic Home Price
Index greater than 20 percent. In those
markets and among borrowers with lower credit ratings ARM shares were notably
higher from 2000 to 2007
Earlier research has shown the interest
rates are key determinants of mortgage decisions and for various reasons FRM
tend to have higher initial rates than ARM.
One of these reasons is pricing for credit risk including credit scores
and income. The margin on an FRM is also
related to conditions such as expected house price appreciation and volatility
and non-loan factors such as prepayment provisions and loan-to-value
ratios. Because of their shorter term ARM
rates are based on a much simpler standard.
Individual borrowers are not necessarily
indifferent to the two loans types.
Earlier research found that borrowers who are likely to move or who are financially
constrained are more likely to choose ARMs which generally have lower
rates. Option ARMS may be especially
attractive to borrowers with incomes that vary from year to year.
Housing market conditions also could
affect borrower mortgage choices. For example, rapid house price increases
could spur demand for homeownership. At the same time, such house price
increases, to the extent lenders ease down payment requirements, may make it
easier for financially constrained borrowers to get credit which could change the
kinds of borrowers who choose ARMs. It
may also have altered the sensitivity of mortgage choice to market metrics such
as the term premium or margins on ARMS and FRMs. Research shows that in speculative bubbles
decisions about buying and financing real estate can be less systematically
linked to fundamentals such as pricing.
The authors examined how rising
house prices affect mortgage choice using a random sample of 6.6 million first
lien mortgages originated from 2000 to 2007 from LPS data and created a model
allowing three choices; an FRM, a non-option ARM and an option ARM and made separate
estimates for home purchases and mortgage refinancing. The model used as key determinants of mortgage
choice financial conditions including a measures of term premium, the slope of
expected short term interest rate, and interest rate volatility and markup for
each mortgage type.
House price appreciation is measured
as the two-year percentage change in the CoreLogic Home Price Index for the
county in which the home is located and volatility is measured as the variation
in the monthly percentage change in the corresponding county-level CoreLogic
index over the two years before a loan's closing date. The model includes
controls for loan terms such as loan-to-value ratio, borrower characteristics
such as credit score, and year-specific effects.
Figure 3 shows that the model
estimates for non-option ARM shares track actual shares over the sample period.
ARM shares generally increased in both high- and low-appreciation markets from
2001 through early 2004. However, during the height of the housing boom, the
ARM share was notably higher in high-appreciation markets.
Rising house prices affected
borrower mortgage choice in high- and low-appreciation markets by a
considerable amount. Borrowers were much
more sensitive to the pace of appreciation in high-appreciation markets but
this had no significant effect on mortgage choice in low-appreciation markets
across all credit risk groups. For
example, for homebuyers in high-appreciation markets, a 15% house price
increase raised the probability of choosing an ARM by about 0.15 percentage
point. But that same house price increase had essentially no effect in
Borrowers purchasing homes in both
high- and low-appreciation markets mostly responded as expected to financial
market metrics. However, in high-appreciation markets they tended to be less
sensitive to loan margins than in low-appreciation markets. Differences in the
effect of the ARM margin were evident, especially among borrowers with low FICO
credit scores. The sensitivities of mortgage choice to some of the market
metrics such as term premium also were statistically different in the high- and
The authors conclude that during the
housing boom, borrowers increasingly opted for ARMs instead of FRMs and this
was most pronounced in markets where house prices rose rapidly. In such
markets, house price gains were strongly correlated with a rising ARMs share
for home purchases. Moreover, in high-appreciation markets, the effects of
fundamentals such as mortgage interest rate margins were muted. This muting
effect was most apparent in ARM margins, that is, the interest rate spread
between ARMs and short-term Treasury yields.