How Homeowners Choose between Fixed and Adjustable Rate Mortgages?

Abstract

Housing is the most important asset in the portfolio of most households. Understanding the households’ decision on housing finance has important implications from a policy perspective, due to the effects it may have on the housing prices, on the housing market stability and on household welfare. The theoretical literature on housing finance focused on figuring out the optimal choice between Fixed Rate Mortgages (FRM) and Adjustable Rate Mortgages (ARM). We argue that the standard economic criteria are sometimes inadequate to explain household’s choices, which may be motivated by psychological factors. In other words, we claim that household’s choice depends only partially on the findings of the theoretical literature. We examine the effect of changes in the short term market interest rate on the households’ choice between fixed rate mortgages (FRM) and adjustable rate mortgages (ARM). We test this effect using a unique data provided to us by the Bank of Israel, which contains detailed information on the household’s decision between fixed and adjustable rate mortgage contracts in Israel in the past decade. The results of our analysis demonstrate a significant association between FRM preference and short term interest rate reduction. Moreover, we find that the change in the short term interest rate is more salient to the borrowers in periods of a high interest rate environment. We attribute these findings to Tversky and Kahneman (1974) availability and representativeness heuristics.

Keywords: Mortgage decision making, household finance, adjustable and fixed rate mortgages, cognitive biases

JEL Classification: D10, D14, G21, R2