Academic journal article
By Leece, David
Real Estate Economics , Vol. 29, No. 4
David Leece (*)
The paper considers the choice of mortgage instrument when the rate of interest is fixed for a short duration, with reversion to a variable (bullet) rate mortgage contract. The research is the first direct test for regressive interest rate expectations using United Kingdom data while testing for wealth and portfolio effects. The econometric modeling uses a variety of nonparametric and parametric techniques to control for classification error in the dependent variable. There is evidence that households adopt regressive interest rate expectations. The lack of statistical significance of wealth and portfolio effects confirms the short run cash flow perspective of United Kingdom mortgage choices.
There is now a wide theoretical and empirical literature on the choice between a fixed rate mortgage (FRM) and an adjustable rate mortgage (ARM) in the United States (Alm and Follain 1987; Sa-Aadu 1987; Bruekner and Follain 1988, 1989; Sa-Aadu and Sirmans 1995) and Canada (Breslaw and Irvine 1996). Econometric work concerned with U.K. mortgage choices is sparse (Leece 1995a, 2000a, 2000b). The research that is reported in this paper significantly extends previous U.K. work on mortgage choices, both methodologically and empirically.
The U.K. mortgage market differs from that in the United States in several important respects. The fixed rate contracts in the United Kingdom (FRMs) are typically fixed for short duration, 1 to 5 years compared with 15 to 30 years. For the sample period 1991 to 1994, there was seldom an option to convert to a further fixed rate contract, and the mortgage reverted back to the variable mortgage interest rate. There was active discouragement of prepayment and remortgaging with other lenders. Currently borrowers can pay from three to six months interest or up to 5% of the debt in redemption costs. (1) In marked contrast to the United States, where prepayment risk is mutualized in the secondary mortgage market, U.K. lenders impose high transaction costs to minimize this risk. These characteristics of U.K. mortgage contracts are important because they give a short run focus to the household's property finance decisions. For example, high redemption penalties reduce the value of the option to prepay and thus narrow the leeway for the adjustment of debt.
The short run nature of U.K. mortgage contracts also arises from the forms of finance used by lenders to fund mortgages. Mortgage lending has typically been financed from short-term retail deposits of banks and building societies. For example, the law restricts building societies to financing mortgage loans by at least 50% using retail deposits, and this percentage is often as high as 75%. Though there has been an increase in "off balance sheet finance," there is no well-developed use of securitized mortgages (see European Mortgage Federation 1998). This contrasts with the United States where a much larger proportion of mortgages is financed via the securitized mortgage market. The link with retail deposits means that U.K. mortgage pricing relates to competition for retail deposits. This adds to uncertainty in that changes in the variable mortgage rate do not immediately reflect changes in the base rate of interest, with the mortgage rate experiencing stickiness. This stickiness is similar and possibly greate r than that for the prime lending rate in the United States. Of course in the United States, adjustable rate debt is indexed, with regular adjustment periods. This distinction is important because anticipating the timing and direction of changes in the variable interest rate will inform U.K. household debt financing decisions and also lead to a focus on the short run.
The above considerations give a study of the U.K. context particular interest. The focus of household choice is likely to be the short period when the tilting of real mortgage payments and other capital market imperfections has most force. …