Choosing Between Fixed and Adjustable Rate Mortgages

40 Pages Posted: 2 Apr 2007

See all articles by Monica Paiella

Monica Paiella

University of Naples Federico II

Alberto F. Pozzolo

Università degli Studi di Roma Tre

Date Written: March 26, 2007

Abstract

This paper estimates the determinants of households' choice between fixed rate (FRM) and adjustable rate mortgage (ARM) contracts, using the Bank of Italy's Survey of Household Income and Wealth. Contrary to the predictions of the theoretical literature, the analysis shows that most household characteristics proxying for exposure to other, non-mortgage-related risks and for individual risk aversion are irrelevant for the choice. This, in turn, crucially depends on the relative price of the mortgages and on whether the household is liquidity constrained. Liquidity constrained households find ARMs particularly attractive because their initial payments are generally lowest. This is so despite some evidence that the premium that lenders charge over their cost of funds is substantially higher on ARMs than on FRMs. Taken together, the evidence suggests that ARM holders do not fully take into account the risk of a rise of the reference interest rates. On the other hand, lenders price quite expensively this risk and borrowers end up paying a high price for the benefit of low initial payments.

Keywords: home purchase finance, adjustable rate mortgages, fixed rate mortgages

JEL Classification: D10, G1, G21, E4

Suggested Citation

Paiella, Monica and Pozzolo, Alberto F., Choosing Between Fixed and Adjustable Rate Mortgages (March 26, 2007). Available at SSRN: https://ssrn.com/abstract=976346 or http://dx.doi.org/10.2139/ssrn.976346

Monica Paiella (Contact Author)

University of Naples Federico II ( email )

Via Amm. F. Acton, 38
80133 Naples, Caserta 80133
Italy

Alberto F. Pozzolo

Università degli Studi di Roma Tre ( email )

Via Ostiense 163
Roma, RM 00154
Italy

HOME PAGE: http://www.uniroma3.it/

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