The Borrower's Perceived Risk in Mortgage Choice

Abstract

We investigate how borrowers perceive the risk in the adjustable rate mortgage (ARM) versus fixed rate mortgage (FRM) choice. We develop a mortgage choice model where the coefficient on the long-term bond risk premium is conditional on the borrower’s perceived risk. We show that the perceived risk fluctuates over time according to the short-term interest rate level and housing market conditions. We find that when the short-term rate level is high (low), the borrowers perceive low (high) risk of a short-term rate rise, thus opting for ARMs (FRMs). Also, during a down housing market they become more risk-averse perceiving higher risk in choosing ARMs. The perceived risk level alters the borrowers’ sensitivity to the long-term bond risk premium.

Keywords: mortgage choice, perceived risk, long-term bond risk premium