Academic journal article
By Lino, Mark
The Journal of Consumer Affairs , Vol. 26, No. 2
The choice between fixed and adjustable rate mortgages can be a very confusing one for borrowers. It can also be a very costly one that could result in much financial distress if a less than optimal choice is made. Recent mortgage borrowers were surveyed to determine whether they could calculate the financial cost of mortgages and which factors influenced their choice. Insights in these areas may produce a better understanding of mortgage choice and be of use to consumer educators in helping consumers select a mortgage. Previous studies of mortgage choice (Albaum and Kaufman 1979; Brueckner and Follain 1986; Colton, Lessard, and Solomon 1979; Dhillon, Shilling, and Dirmans 1985; Horowitz 1985; Turner 1979) focused only on the economic aspect of the choice or were limited to the use of secondary data in estimating their models.
The conceptual model of this study is based on an economic environment in which lenders expect mortgage interest rates to rise over borrowers' average residencies in homes. These rates vary year to year, but the overall trend is upward. Hence, contract rates on adjustable rate mortgages are below those on fixed rate mortgages. The choice between fixed and adjustable rate home loans is hypothesized to be influenced by lender constraints, financial cost of mortgages, compatibility of mortgages to financial plans, and riskiness of mortgages.
Lender Constraints Regarding Mortgage Choice
Lenders limit mortgage choice by the type of loans they offer and the eligibility requirements they establish. Typically, lenders only offer fixed and adjustable rate mortgages. If lenders do not offer a choice between these mortgages, then borrowers have no choice if they want to purchase a home. Mortgage eligibility requirements set by lenders primarily concern the maximum loan for which borrowers may qualify. Lenders employ various methods to determine this figure, but one of the more important methods is the monthly mortgage payment to borrower income ratio. Beginning mortgage payments cannot exceed a certain percentage of borrowers' income. Because this method for determining eligibility is often the same for fixed and adjustable rate mortgages, in the economic environment of the model, borrowers can qualify for larger loan amounts with adjustable as opposed to fixed rate mortgages. Adjustable rate mortgages have lower initial interest rates and, consequently, lower beginning payments. Hence, if borrowers choose the maximum loan amount, they may be constrained by eligibility requirements and be more likely to choose adjustable rate mortgages.
Financial Cost Aspect of Mortgage Choice
For economically rational borrowers, differences in expected financial costs between fixed and adjustable rate mortgages are determined by these borrowers' expectations of future interest rates and length of residencies in homes. From the lenders' viewpoint, at the time of loan origination, the expected present values of payment streams on fixed and adjustable rate mortgages are equivalent, although the actual payment streams on the two loans differ (adjustable rate mortgages have lower mortgage payments in the earlier years and higher payments in later years, assuming an economic environment where interest rates rise over the average loan term). The expected present value equivalency is due to lenders incorporating their expectations of future interest rates and average residencies in homes in determining contract rates on fixed rate mortgages. Hence, if borrowers are economically rational and share these lender expectations, they would believe both fixed and adjustable rate mortgages have the same expected financial cost and be indifferent between the two loans.
However, if borrowers are economically rational and do not share lender expectations of future mortgage interest rates or length of residencies in homes, they would believe one mortgage type has a higher expected cost. …