Adjustable and Fixed Rate Mortgages as a Screening Mechanism for Default Risk

Posted: 1 Sep 2004

See all articles by Lisa Lipowski Posey

Lisa Lipowski Posey

Pennsylvania State University - Department of Insurance & Real Estate

Abdullah Yavas

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics

Abstract

This paper studies how borrowers with different levels of default risk would self-select between Fixed Rate Mortgages (FRMs) and Adjustable Rate Mortgages (ARMs). We show that under asymmetric information, where the risk type of a borrower is private information to the borrower and not known by the lender, the unique equilibrium may be a separating equilibrium in which the high-risk (low-risk) borrowers choose ARMs (FRM's). Thus, the borrower's mortgage choice will serve as a signal of default risk, enabling lenders to screen high-risk and low-risk borrowers. It is possible for the separating equilibrium to yield positive economic profits for lenders in a competitive market. It is also possible to have a unique pooling equilibrium where all borrowers choose either FRMs or ARMs. The model implies that an increase in the proportion of high risks will increase the likelihood of a separating equilibrium where both mortgage types are offered. Also a uniform downward shift in the expected change in the interest rate or an increase in borrowers' current or future incomes make ARMs more attractive for both types of borrowers.

Keywords: Default risk, separating equilibrium, ARM, FRM

JEL Classification: D82, G21

Suggested Citation

Posey, Lisa Lipowski and Yavas, Abdullah, Adjustable and Fixed Rate Mortgages as a Screening Mechanism for Default Risk. Journal of Urban Economics, Vol. 49, pp. 54-79, 2001. Available at SSRN: https://ssrn.com/abstract=584261

Lisa Lipowski Posey

Pennsylvania State University - Department of Insurance & Real Estate ( email )

University Park, PA 16802-3306
United States
814-865-4172 (Phone)
814-865-6284 (Fax)

Abdullah Yavas (Contact Author)

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics ( email )

School of Business
975 University Avenue
Madison, WI 53706
United States

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