How Do 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 (FRMs) and adjustable rate mortgages (ARMs). 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 FRMs and ARMs. 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 FRM and ARM 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.

Reviewing cognitive distortions in managerial decision making

“…This results from the application of the representativeness heuristic, explicated as "restricting internationalization to English-speaking markets," driven by the simplicity in entering contexts featuring a similar culture. Although in different contexts, Jones (2015) and Mugerman et al (2016) similarly find that availability and representativeness interact, with the former affecting the latter. For example, Mugerman et al (2016) discover that decision makers facing long-term investments are influenced first by the short-term interest rate changes available, that later can be representative of fixed or adjustable rate decisions.…”

“…Although in different contexts, Jones (2015) and Mugerman et al (2016) similarly find that availability and representativeness interact, with the former affecting the latter. For example, Mugerman et al (2016) discover that decision makers facing long-term investments are influenced first by the short-term interest rate changes available, that later can be representative of fixed or adjustable rate decisions.…”

“…This results from the application of the representativeness heuristic, explicated as "restricting internationalization to English-speaking markets", driven by the simplicity in entering contexts featuring a similar culture. Although in different contexts, Jones (2015) and Mugerman et al (2016) Graffin et al (2013) find that CEO candidates having experience in that position lead the governance to apply representativeness, through which potential directors are perceived as more successful than others that do not have this background; being seen as similar to the current CEO, in practice, gives more chances -at least 60% more -of not being replaced in the first years of tenure.…”

Adjustable-rate mortgages in the era of global reflation: How to model additional default risk?

“…Berlinger [ 12 ] argued that the calculation method of APRC misleads the borrowers and strengthens their myopic view. Several authors found that personal traits and psychological effects also play a role in borrowers’ choice [ 13 – 15 ], while Albertazzi et al [ 16 ] and Gathergood and Weber [ 17 ] emphasized the effects of education and financial literacy. The product characteristics are more complicated in the case of ARMs as compared to FRMs since installments are not a linear function of interest rates [ 18 ].…”