Choice of Mortgage Contracts: Evidence from the Survey of Consumer Finances

Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Choice of Mortgage Contracts: Evidence from the Survey of Consumer Finances Brahima Coulibaly and Geng Li 2007-50 NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

Choice of Mortgage Contracts: Evidence from the Survey of Consumer Finances Brahima Coulibaly and Geng Li (cid:3) Board of Governors of the Federal Reserve System August 30, 2007 Abstract This study revisits the empirical question of the determinants of the choice between (cid:133)xedand adjustable-rate mortgages using more comprehensive data from the Survey of Consumer Finances(SCF)thatovercomesomeofthedatalimitationsinpreviousstudies. Theresultsfrom aLogitmodelofmortgagechoiceindicatethatpricingvariablesanda⁄ordabilityareimportant considerations. We also (cid:133)nd that factors such as mobility expectations, income volatility, and attitudestoward(cid:133)nancialrisklargelyin(cid:135)uencemortgagechoice,withmorerisk-averseborrowers preferring (cid:133)xed-rate mortgages. For households that are less risk averse, the mortgage type choicedecisionislesssensitivetopricingvariablesandincomevolatility,anda⁄ordabilityfactors are not signi(cid:133)cant. These (cid:133)ndings provide empirical support that underscore the importance of attitudes toward risks in mortgage choice. Keywords: Mortgage contracts, Risk aversion, Household (cid:133)nance, Fixed-rate, Adjustable-rate JEL classi(cid:133)cations: D10, G11, G21, R2 Coulibaly: Economist, Division of International Finance, Board of Governors of the Federal Reserve (cid:3) System, Washington, DC, 20551; Li: Economist, Division of Research and Statistics, Board of Governors of the Federal Reserve System, Washington, DC, 20551. We thank Karen Dynan, Catherine McDevitt, Karen Pence, Nela Richardson, Shane Sherlund, and seminar participants at Federal Reserve Board, the Midwest Economic Association Meetings, and the 2007 American Real Estate and Urban Economics Association mid-year meetings for helpful comments and discussions. The views expressed in the paper are those of the authors and do not necessarily re(cid:135)ect those of the Board of Governors or the Federal Reserve System. 1

1 Introduction Innovationsinthemortgagemarketintheearly1980spresentedhomebuyerswithalternative(cid:133)nancial instruments to the traditional (cid:133)xed-rate mortgage. Since then, typical borrowers have faced the choice between (cid:133)xed- and adjustable-rate mortgages (FRMs and ARMs), the two dominant (cid:133)nancial instruments in the primary market. Understanding the factors that in(cid:135)uence the choice of one mortgage type over the other has continued to attract a signi(cid:133)cant amount of research interest in the (cid:133)eld of household (cid:133)nance given the importance of real estate wealth in a typical household(cid:146)s portfolio.1 There are two broad categories of factors that can in(cid:135)uence mortgage choice: relative pricing and other terms of the contract, and borrower characteristics (a⁄ordability, mobility expectation, and demographics). The theoretical research on the subject has generally documented the importance of both borrowers(cid:146)characteristics and price factors (see, for example, Brueckner, 1986; and Alm and Follain, 1987). Alm and Follain (1984) highlight the importance of income and borrowing constraints, and Stanton and Wallace (1999) discuss the importance of interest-rate risks.2 More recently, Campbell and Cocco (2003) solve a dynamic model of mortgage choice, and (cid:133)nd that households that are borrowing-constrained with low risk aversion should prefer ARMs. They (cid:133)nd that households that are not borrowing-constrained should also prefer ARMs when in(cid:135)ation risks are large relative to real interest rate risks. On the other hand, a household with a large mortgage, risky labor income, high risk aversion, a high cost of default, or a low probability of moving should prefer FRMs. The existing empirical studies have generally documented a dominant role for pricing variables, but little or no role for borrower characteristics. In principle, if (cid:133)nancial markets are perfect and complete, all borrower characteristics and actions would be re(cid:135)ected in the prices and terms of mortgage contracts. In practice, however, the presence of asymmetric information between lenders andborrowerssuggeststhatborrowercharacteristicscouldberelevantinmortgagechoice. Previous studies either used local data sets with small samples (Dhillon, Shilling, and Sirmans, 1987; Sa- Aadu and Sirmans, 1995) or national survey data with limited or no information on borrower characteristics (Brueckner and Follain, 1988; Nothaft and Wang, 1992; Boyd, 1992). The goal of this paper is to further contribute to the empirical literature by revisiting the determinants of 1Housing wealth makes up more than 50 percent of the total wealth for U.S. households between the 40th and 80th percentiles of the national wealth distribution. See Campbell and Cocco (2003). 2Additional references include Baesel and Biger (1980), Smith (1987), and Statman (1982). 2

mortgage choice while overcoming some of the data limitations in previous studies. The Survey of Consumer Finances (SCF) has a large sample that is representative of the U.S. mortgage market. It contains comprehensive data on mortgages, as well as on broader household (cid:133)nancesanddemographics. Inaddition, itcontainsdirectmeasuresofhouseholds(cid:146)attitudestoward (cid:133)nancial risk and moving expectations, and contains data that allow us to estimate the riskiness of household income(cid:150)three important borrower characteristics documented in the study by Campbell andCocco. Datasetsusedinpreviousempiricalstudiescontainalmostnoinformationonborrowers(cid:146) attitudes toward risk and little information on mobility.3 For mobility, the existing studies have used two proxies(cid:150)the number of years at current address (Dhillon, Shilling, and Sirmans, 1987; Brueckner and Follain, 1988) and indicators for whether the borrower is new to the metropolitan area (Boyd, 1992). Goodman (1982) (cid:133)nds that tenure at the present address is an indicator for future mobility. Using this measure in empirical studies has, however, yielded mixed results for the e⁄ect of mobility on mortgage choice, which may owe to the fact that tenure is a poor indicator for future relocation expectations as suggested by Boyd (1992). In addition to attitudes toward risk and mobility expectations, we are also able to construct a measure of riskiness of household income. To our knowledge, this is the (cid:133)rst study to revisit mortgage choice in recent years using such a comprehensive data set. Results from a Logit model con(cid:133)rm (cid:133)ndings in earlier studies that pricing variables and terms of the contract, namely the FRM-ARM interest rate spread, the yield curve slope, and the length of the mortgage are important considerations in mortgage choice. We (cid:133)nd that a higher spread, a lower yield curve slope, and longer mortgages make households more likely to choose an ARM. A⁄ordability and (cid:133)nancial stress also play an important role, with households that are more (cid:133)nancially constrained tending to choose ARMs. A unique (cid:133)nding of this paper is the importance of risk factors. Borrowers who are more risk-averse, have risky income, or that are less likely to move in the near term tend to prefer FRMs. Further, we (cid:133)nd that when the sample is split according to attitudes toward risk, the main results are preserved for the more risk-averse sub-sample. For households that are less risk averse, we (cid:133)nd that the mortgage type choice decision is less sensitive to pricing variables and income volatility, and a⁄ordability factors are not signi(cid:133)cant. In the remainder of the paper, we (cid:133)rst motivate the empirical speci(cid:133)cation using a simple 3Some studies have attempted to use family size as a proxy for risk aversion. Presumably, the presence of children in the house could be correlated with attitudes toward risks. See Brueckner and Follain (1988). 3

conceptual framework of mortgage choice that highlights the role of borrower characteristics and pricing variables. In section 3, we describe the SCF data and sample construction methodology. In section 4, we estimate the Logit model and present the results. Section 5 concludes. 2 A Simple Conceptual Framework of Mortgage Choice Consideramortgagemarketpopulatedwithcompetitiveborrowersandamonopolisticlender.4 The borrowershaveheterogeneous(cid:133)nancialstatesandpreferences,whicharesummarizedbyaborrower characteristics vector (cid:18). The distribution of (cid:18) is given by the cumulative density function J((cid:18)) and the support of (cid:18) is (cid:2). To simplify the analysis, we assume that there are two types of mortgage contracts, a FRM and an ARM, and the lender must o⁄er both contracts to each borrower. The two types are identical in terms of maturity, front-loaded points, prepayment options and other features, except for the interest rates in the initial periods. Let R and R denote the initial F A interest rate of the FRM and ARM contract, respectively. Typically we have R > R . F A Assume that the lender has perfect information on (cid:18) for each individual borrower and the cost ofo⁄eringacustomizedmortgagecontractiszerosothatthelendercanimplement(cid:133)rst-orderprice discrimination against the borrowers. For each borrower i, the lender will o⁄er a pair of Ri and F Ri so that the borrower is indi⁄erent between the two contracts, and indi⁄erent between whether A or not to apply for the loan. Let Vi = V(Ri ; (cid:18)i) and Vi = V(Ri ; (cid:18)i) be the borrower(cid:146)s payo⁄. If F F A A the corresponding FRM or ARM contract is chosen, we have Vi = Vi (1) F A However, in a market where the lender cannot implement (cid:133)rst-order price discrimination either because he lacks the crucial information of (cid:18) for each individual borrower or because the cost of o⁄ering customized contracts is very high, the lender will choose to o⁄er only limited pairs of R F and R to maximize the total pro(cid:133)t. In the polar case where the lender has no information about A the individual borrower and, therefore, cannot price discriminate, only one pair of R and R is F A o⁄ered to the entire market. The borrowers, facing such a pair of contracts, will make a choice according to the following criteria: 4A similar mortgage choice can be derived in a competitive lending market as well. 4

Vi = V(R ; (cid:18)i) > V(R ; (cid:18)i) = Vi = Choose a FRM F F A A ) 8 (2) > > > < Vi = V(R ; (cid:18)i) < V(R ; (cid:18)i) = Vi = Choose an ARM: F F A A ) > > Let (cid:5)(R ) and>(cid:5)(R ) be the lender(cid:146)s pro(cid:133)t from each contract. The lender(cid:146)s pro(cid:133)t maximization F : A problem is max (cid:5)(R ) 1(Vi > Vi)+(cid:5)(R ) 1(Vi < Vi) dJ((cid:18)); (3) F F A A F A RF;RA Z (cid:18) 2 (cid:2) (cid:2) (cid:2) (cid:2) (cid:3) where 1( ) is the indicator function, taking on value 1 when its argument is true. Our paper does not attempt to pin down endogenously the equilibrium R and R given J((cid:18)). F A Rather, we ask, given the market equilibrium interest rate for each type of mortgage contract, R F(cid:3) andR ,andtheborrowers(cid:146)characteristics: towhatextentdoesthisinformationhelpuspredictthe A(cid:3) mortgage choice of each borrower? Linearizing the value function V(R;(cid:18)), the borrower(cid:146)s decision problem can be rewritten as the following, (cid:9)i = (R ;R ;M ;(cid:18)i)+(cid:15)i; (4) F(cid:3) A(cid:3) 0 where (cid:15)i is a stochastic error term and M is a vector of macro variables that typically include the slope of the yield curve. The borrower i chooses a ARM contract if (cid:9)i > 0 and an FRM contract if (cid:9)i 0. (cid:20) 3 Data Description We use nationwide household survey data, the Survey of Consumer Finances (SCF). The SCF is a triennial cross-sectional survey conducted by the Federal Reserve Board. The main objective of the survey is to help policymakers and researchers understand households(cid:146)(cid:133)nances. It collects extensive and high quality data on household (cid:133)nances and characteristics, including demographics. In recent waves, the SCF surveyed more than 4,000 households, and has tended to oversample wealthy households. The SCF applies multiple imputations to many variables to limit missing values.5 The disadvantage of the multiple imputations is that it biases the standard errors in a regression analysis. We correct for this bias during estimation using the procedure provided by the 5The other purpose of multiple imputation is to protect the identity of the households in the sample. 5

SCF.6 The SCF collects rich data on households(cid:146)mortgages, (cid:133)nancial assets, and demographics. The survey asks homeowners whether their mortgages are ARMs. We use these self-reported data to capture the mortgage type. The SCF also collects data on other characteristics of the mortgage such as the initial mortgage year, the initial price, payments and so on.7 For household (cid:133)nances (income, debt, assets, etc...) or demographics, the survey captures these data in the year of the interview, not in the initial year of the mortgage. To remedy this de(cid:133)ciency, we restrict the sample tohouseholdswithmortgagesthathave beenoriginated withintwoyearsof the interviewdate. For example, if a household(cid:146)s mortgage was originated in 1990 and the SCF surveyed the household in the 1992 wave, we assume that data collected in 1992 should be quite close to what the household would have reported if it was surveyed in 1990. Finally, because some key variables of interest, such as expectations about moving, are only available from the 1995 wave forward, we use only four waves of the SCF data (1995, 1998, 2001, and 2004). We obtain 17,565 observations, of which 3,636 have mortgages that are two years old or younger. Further, we exclude households that reported living on a ranch or farm, households who reported inheriting the mortgage from the previous owner, and households whose head is younger than 24 years or older than 65 years. Finally, we trim o⁄the top one percent of the distribution of thecontinuousandratiovariables. Afterthesampleselectionprocedure, wehave2,887households. 4 Variables Description and Estimation Results 4.1 Variables Description We estimate the following Logit model of mortgage type choice: L = 1 (cid:9)i > 0 i (cid:0) (cid:1) where L = indicator for ARM mortgage. It is 1 if borrower i has an ARM and 0 otherwise. i 6For details see the SCF codebook (http:==www:federalreserve:gov=pubs=oss=oss2=2004=scf2004home:html) 7However, the survey does not collect information that would allow us to identify non-traditional mortgages such as (cid:147)interest only(cid:148)or (cid:147)negative amortization(cid:148)loans. 6

SPREAD;YC;SM;REFI;SUBP;OPSD;MBIR;TDIR;MOB;RISK (cid:9)i = +(cid:15)i INCVOL;STOCK;EDUC;AGE;RACE;FAMSIZE;MS ! where SPREAD: di⁄erence between FRM and ARM interest rates YC: di⁄erence between the yield on the 10-year Treasury-note and the 1-year Treasury-bill SM: indicator for whether the mortgage maturity is 15 years or less REFI: indicator for whether household is re(cid:133)nancing SUBP: indicator for whether the mortgage is subprime OSPD: indicator for whether households spent more than they earned in the previous year MBIR: ratio of the mortgage balance to household income TDIR: ratio of total household non-housing debt to income MOB: probability that the household will move in the near term RISK : household(cid:146)s attitude toward risk INCVOL: volatility of household income standardized by the level of income STOCK: indicator for (cid:133)nancially "sophisticated" given by whether households directly hold stocks EDUC: indicator for college graduate AGE: age of the head of the household RACE: indicator for whether the head of the household is white FAMSIZE: number of family members in the household MS: indicator for whether household is married In the SCF, homeowners are asked (cid:147)Is this an adjustable rate mortgage; that is, does it have an interest rate that can rise or fall from time to time?(cid:148). We classify homeowners as having an ARM if the answer to this question is yes. Figure 1 depicts the evolution of the ARM origination share in the SCF in comparison to the origination share published by the Mortgage Bankers Association (MBA).Asthechartshows, thedynamicsoftheARMoriginationshareintheSCFareverysimilar to that of the MBA.8 A positive and statistically signi(cid:133)cant coe¢ cient on an independent variable indicates that a highervalueofthevariablemakesthehouseholdmorelikelytochooseanARM.IntheSCFdatawe only observe the interest rate of the contracts that homeowners chose, but not the o⁄ered interest rate of the alternative contracts. Therefore, we use the market average spread to approximate the household speci(cid:133)c spread (SPREAD).9 Ceteris paribus, a wider FRM-ARM spread means that the (cid:133)xed-rate mortgage is more costly, and makes homeowners more likely to choose an ARM. 8TheMBAindexlevelishigherthantheSCFlevelconsistentlyafter1998,possiblyre(cid:135)ectingconceptualdi⁄erences (MBA index is application based, whereas the SCF share is transaction based) or sampling error. 9These data were obtained from the Mortgage Bankers Association. 7

Therefore we expect the estimated coe¢ cient of SPREAD to be positive. The yield curve (YC) is the di⁄erence between interest rates on the 10-year Treasury note and the 1-year Treasury bill. Assuming the Fisher Hypothesis holds, a steeper yield curve implies the expected future shortterm interest rate will be higher than the contemporaneous short-term interest rate. Consequently, homeowners have a stronger incentive to choose a FRM to lock in the current interest rate. This suggests a negative coe¢ cient for the yield curve (YC). Because SPREAD and YC are economywide variables, including them in estimation also likely controls for part of the time series variation in ARM origination shares, and other macroeconomic factors. The mortgage maturity is an important component of the contract. We control for it by including a dummy variable SM that is equal to 1 for mortgages shorter than or equal to 15 years, and zero otherwise. Anecdotal evidence suggests that a large share of ARM contracts o⁄ered are long-term, mostly 30-year, contracts. In this case, short-term mortgages would tend to be FRMs, and yield a negative coe¢ cient on SM. Similarly, we also control for whether the mortgage is subprime (SUBP) since more than two-thirds of subprime mortgages are ARMs. The SCF data do not report directly whether a mortgage is subprime; we approximate it using interest rate spreads. IfthemortgageinterestrateismorethanthreepercentagepointshigherthantheTreasury security of comparable maturity, we consider it subprime. By this approximation, 11.5 percent of mortgages in our sample are subprime. A⁄ordability and (cid:133)nancial constraints are also expected to in(cid:135)uence mortgage choice, as documented in some of the previous studies (e.g. Nothaft and Wang, 1992). The SCF collects comprehensive data on household (cid:133)nances. For example, households are asked explicitly whether total expenditures exceeded total earnings in the previous year. We include this variable (OSPD) to capture the household(cid:146)s potential (cid:133)nancial stress around the time of the purchase. To further capturethee⁄ectof(cid:133)nancialstressonmortgagechoice, wealsoincludethemortgagesizetohousehold income ratio (MBIR) and the non-housing debt balance to household income ratio (TDIR). Our hypothesis is as follows: If a homeowner is under some (cid:133)nancial stress, either because the mortgage is too large relative to income or because other expenditures have squeezed out too much income, the homeowner would want to lower the mortgage payment in the near term in order to deal with the (cid:133)nancial pressure. Other factors held constant, an ARM contract would initially o⁄er lower payments than a FRM contract. Then the homeowner would prefer an ARM to a FRM contract. Therefore the coe¢ cients on OSPD, MBIR and TDIR tend to be positive. 8

Besidespricingvariablesanda⁄ordability, theSCFdatahastheuniqueadvantageofcontaining direct measures of future mobility expectations and households(cid:146)attitudes toward (cid:133)nancial risk. On mobilityexpectation, thesurveyasksthefollowingquestion: (cid:147)We are interested in your view of the chance that you will be staying at your current address for the next two years. Using any number from zero to 100, where zero equals no chance and 100 equals absolutely certain, what do you think the chances are that you will be living at your current address two years from now?(cid:148)This index measures the likelihood of staying at the same address. We subtract this index from 100 and divide the di⁄erence by 100 to normalize it to a probability measure of moving in the next two years (MOB). When a household moves, it typically has to sell the house and terminate the current mortgage. If the household expects to move within a short period of time, it would likely choose an ARM to bene(cid:133)t from the lower payments it o⁄ers in the initial years. To capture attitudes toward risk, the SCF asks households if they would "take substantial (cid:133)nancial risks expecting to earn substantial returns," "take above average (cid:133)nancial risks expecting to earn above average returns," "take average (cid:133)nancial risks expecting to earn average returns" or "not take any (cid:133)nancial risks." We de(cid:133)ne a household as more risk-averse (RISK) if the household revealsthatitwould"take average (cid:133)nancial risks expecting to earn average returns"or"not to take any (cid:133)nancial risks." One possible reservation about the risk attitude variable is whether it truly captures households(cid:146)attitudes toward risk, and whether it matters for their (cid:133)nancial decisions. We believe it does. Similar questions focusing on understanding households(cid:146)attitude toward (cid:133)nancial risk are also asked in the Health and Retirement Survey (HRS) and the Panel Study of Income Dynamics (PSID) data. Barsky, Juster, Kimball, and Shapiro (1997) provide a validation of the HRS (cid:133)nancial risk attitude questions by showing signi(cid:133)cant correlation of responses to the risk question with the other types of risk taking behaviors. In a similar spirit, we (cid:133)nd that the risk aversion variable is negatively correlated with risky (cid:133)nancial actions such as self-employment or the holding of stocks.10 Campbell and Cocco (2003) suggest that more risk averse homeowners are more likely to choose a FRM. This prediction implies the coe¢ cient on the risk aversion dummy to be negative. In addition, as Campbell and Cocco (2003) point out, income volatility is an important consideration when households choose between mortgage types. Because an ARM contract induces 10The correlation with self-employment and stock ownership are -0.24 and -0.13, respectively, and they are statistically signi(cid:133)cant from 0. 9

possible changes in monthly payments, a household with volatile income is more likely to default if income declines and mortgage payments increase. To minimize the likelihood of such scenarios, homeowners with volatile income would be more inclined to choose a FRM, especially if they are risk averse. Ideally, we would like to measure the homeowner(cid:146)s perceived future income volatility. This information is not available in the SCF. Instead, we use the cross section income volatility to approximate the riskiness of future income. We estimate the following version of the Mincer equation by occupation using real household income data de(cid:135)ated by the 1982-1984 CPI and the age, education, and race of the head of household: Income = (cid:11) Age+(cid:11) Age2+(cid:11) Edu+(cid:11) Race+(cid:11) YearDummies+(cid:22): (5) 1 2 3 4 5 We pool together the residual ((cid:22)) and calculate its standard deviation by occupation. The income volatility measure (INCVOL) we use in the Logit regression is the ratio of (cid:22) to the household(cid:146)s real income. Finally, we include a dummy variable for stock ownership. This is motivated by Bucks and Pence (2006) who (cid:133)nd that many households do not recall the more complicated terms of their ARM contracts, such as their exposure to interest rate changes within the mortgage contract period. Our stock ownership dummy (STOCK) helps to capture this e⁄ect under the assumption that more (cid:133)nancially sophisticated investors understand their ARM contracts better, and therefore are more likely to choose ARMs. We present in Table 1 summary statistics for the entire sample and for the "more risk averse" and "less risk averse" sub-samples. 4.2 Estimation Results The results of the estimation using the entire sample are reported in Table 2. We report the estimated coe¢ cients, standard errors, and the odds ratio. For dummy variables, the odds ratio is calculated between "0" and "1". For integer variables, the odds ratio is calculated by increasing the variable by one unit, and for continuous variables, the odds ratio is calculated by increasing the variable by one standard deviation. Broadly speaking, the explanatory variables included in our model covers four categories of factors that will a⁄ect households(cid:146)mortgage choice (cid:150)priceand contract-related variables, a⁄ordability- and (cid:133)nancial stress-related variables, risk factors, and demographics. The results for the entire sample are reported in columns 2-4. 10

We (cid:133)rst look at the price- and contract-related factors. The FRM-ARM spread coe¢ cient is positive and the yield curve coe¢ cient is negative as expected. Both are statistically signi(cid:133)cant, suggesting that the price variables signi(cid:133)cantly a⁄ect mortgage type choice, and the e⁄ects are consistent with (cid:133)ndings in previous studies. The coe¢ cients are signi(cid:133)cant in an economic sense as well. The odds ratio estimated for SPREAD suggests that an increase of one standard deviation in the spread between the FRM interest rate and the ARM interest rate will lead the homeowners to be 42 percent more likely to choose an ARM. A similar increase in the yield curve (YC) slope decreases the likelihood of choosing an ARM by 28 percent. The coe¢ cient for mortgage length dummy (SM), another important factor of mortgage contracts, is negative and highly signi(cid:133)cant, indicatingthatmortgagesshorterthan(cid:133)fteenyearsaremorelikelytobeFRMs. Manylendersonly o⁄er 30-year contracts for ARMs, and they o⁄er contracts with short terms for FRMs. However, with some caveats, this result could also be viewed as supportive evidence for the a⁄ordability argument(cid:151) other things held constant, if the homeowner can a⁄ord to pay o⁄ the debt within a shorter period, he or she is less likely to encounter a⁄ordability and liquidity challenges, and hence should choose a FRM. In addition, the re(cid:133)nance dummy (REFI) has a negative and signi(cid:133)cant coe¢ cient, suggesting that when a homeowner re(cid:133)nances, he or she is more likely to re(cid:133)nance the existing mortgage into a FRM. This is not surprising since one important motivation of households for re(cid:133)nancing is to lock in attractive interest rates. Re(cid:135)ecting the predominance of subprime mortgages that are issued as ARMs, we (cid:133)nd a positive and statistically signi(cid:133)cant coe¢ cient on SUBP. Our second category of variables focuses on the a⁄ordability, (cid:133)nancial stress and liquidity measures (MBIR, OSPD, and TDIR). The overspending dummy OSPD has a signi(cid:133)cant positive coe¢ cient. The odds ratio suggests that households that spent more than they earned were 27 percent more likely to choose an ARM relative to the households that did not. Overspending households face greater (cid:133)nancial pressure and are likely to be liquidity constrained. An ARM is attractive for these households because it provides lower payments in the initial years of the mortgage before the interest rate is adjusted. The coe¢ cient on the balance-to-income ratio MBIR is positive and signi(cid:133)cant. We view this as the evidence of a⁄ordability concerns. The larger the mortgage balance is relative to income, the greater the (cid:133)nancial pressure and hence the more attractive the ARM. Last, we (cid:133)nd a positive coe¢ cient for the total non-housing debt-to-income ratio TDIR, but the coe¢ cient is not statistically signi(cid:133)cant. All told, the balance of the evidence 11

suggests that households that are more (cid:133)nancially constrained are more likely to prefer ARMs. Turningtoriskfactors,thecoe¢ cientforincomevolatilityisnegativeandstatisticallysigni(cid:133)cant suggesting that households with a one standard deviation more volatile income are 36 percent less likely to choose an ARM. The moving prospect variable is positive and statistically signi(cid:133)cant, in contrast to (cid:133)ndings in Boyd (1992) who used an indicator for whether the household is new in the metropolitan area as a proxy for mobility.11 Households that are more likely to move prefer ARMs to capture the lower payments in the near term. Other variables held constant, a one standard deviation increase of the reported moving likelihood increases the likelihood of choosing an ARM by 10 percent. The coe¢ cient on risk aversion is negative and statistically signi(cid:133)cant suggesting more risk averse households are 24 percent less likely to choose an ARM. In sum, households that are more risk averse, less likely to move, or households with more risky income prefer FRMs. These (cid:133)ndings are consistent with the theoretical predictions in Campbell and Cocco (2003). They are also consistent with recommendations of some personal (cid:133)nance books. For example, Tyson and Brown (2000) recommend that households with short expected tenure should choose an ARM to take advantage of the lower interest rate it o⁄ers in the initial years of the mortgage. Similarly, Fisher and Shelly (2002) warn that ARMs are risky and recommend FRMs as safe and dependable. The results from this study suggest that borrowers consider these risk factors when making a mortgage choice. ARM contracts tend to be more di¢ cult to understand and this could bias households with less (cid:133)nancial sophistication toward FRMs. To control for this type of error, we include an indicator for stock ownership and education. Presumably, households that own stocks or that are college graduates are likely to be more (cid:133)nancially sophisticated. The results indicate that households that are more (cid:133)nancially sophisticated or educated are about 50 percent more likely to choose ARMs. Finally,consistentwithresultsinseveralpreviousstudies,we(cid:133)ndnoevidencethatstandard demographic variables such as race, family size, or marital status play a role in mortgage choice. A novel (cid:133)nding in this study is the e⁄ect of households(cid:146)attitudes toward risk as measured by their revealed risk preferences. To further understand the e⁄ect of attitudes toward risk on mortgage choice, we split the sample by risk category. Table 1 presents the summary statistics of the more risk-averse and less risk-averse groups, respectively. About 60 percent of households in 11Brueckner and Follain (1988) also used an indicator for whether the household is new in the metropolitain area. Dhillon,Shilling,andSirmans(1987)usedtenureatpresentaddressasproxyformobilityprospect. Both(cid:133)ndresults consistent with (cid:133)ndings in this study. 12

our sample are more risk-averse. As noted previously, we (cid:133)nd that fewer households in the more risk-averse sample own stocks. In addition, the more risk-averse sample, on average, has a lower level of education, takes smaller mortgages, and tends to choose FRMs. We run a Logit model for each sub-sample. The results are reported in columns 5-7 of Table 2 for the more risk-averse sample and in columns 8-10 of the same table for the less risk-averse sample. We (cid:133)nd that for the more risk-averse group, most of the coe¢ cients that are signi(cid:133)cant for the entire sample remain signi(cid:133)cant with the same sign. The exception is for moving expectation which becomes insigni(cid:133)cant. The results for the less risk-averse group are also similar for most variables except for a⁄ordability factors, which becomes insigni(cid:133)cant. Comparing the magnitude of thecoe¢ cientsforthetworiskcategories,we(cid:133)ndthattheestimatedcoe¢ cientsfortheFRM-ARM interest rate spread, income volatility, and the yield curve are smaller in magnitude for the less risk-averse sample. We interpret these (cid:133)ndings to suggest less risk averse borrowers are less likely to be concerned with their ability to sustain their mortgage payments, and that pricing variables and income risk do not in(cid:135)uence mortgage choice for these households as much as they do for the more risk averse borrowers. 5 Conclusion This paper revisits the empirical evidence on the determinant of mortgage choice using more comprehensive data from the Survey of ConsumerFinances (SCF). The rich nature of the survey allows us to circumvent some of the data limitations in previous studies. The results from a simple Logit model indicate that pricing variables and terms of the contract are important considerations in mortgage choice. A⁄ordability and (cid:133)nancial stress also play an important role. A unique (cid:133)nding of this paper is the importance of risk factors. Borrowers who are more risk averse, have risky income or are less likely to move in the near term tend to prefer FRMs. Further, we (cid:133)nd that attitudes toward risk a⁄ect mortgage choice along two important dimensions: For less risk-averse borrowers, a⁄ordability factors do not signi(cid:133)cantly a⁄ect mortgage choice, and pricing variables and income volatility do not in(cid:135)uence their mortgage choice to the same extent as that of more risk-averse borrowers. We view these results as supportive empirical evidence on the essential role of attitudes toward risk in the choice of mortgage contracts. 13

References [1] Alm, James and James R. Follain (1984). "Alternative Mortgage Instruments, the Tilt Problem, and Consumer Welfare". Journal of Financial and Quantitative Analysis 19:1 (March), 113-26. [2] Alm, James and James R. Follain (1987). "Consumer Demand for adjustable rate mortgages," Housing Finance Rev. 6, 1-16. [3] Barsky, B., F. T. Juster, M. Kimball, and M. Shapiro (1997). "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," Quarterly Journal of Economics (May), 537-579. [4] Baesel, Jerome B., and Nahum Biger. (1980). "The Allocation of Risk: Some Implications of Fixed Versus Index-Linked Mortgages," Journal of Financial and Quantitative Analysis 15 (June), 457-468. [5] Boyd, W. James. (1992). "Asset-Status Proxies and Consumer Preference for ARMs: An Empirical Investigation Using Probit Analysis," The Journal of Real Estate Research, Vol. 3 issue 1 (Spring). [6] Brueckner, J. (1986). "The pricing of interest rate caps and consumer choice in the market for adjustable-rate mortgages," Housing Finance Rev. 5, 119-136. [7] Brueckner, J., and J.R. Follain. (1988). "The Rise and Fall of the ARM: An Econometric Analysis of Mortgage Choice," Review of Economics and Statistics 70, 93-102. [8] Bucks, BrianandKarenPence.(2006)."DoHomeownersKnowTheirHouseValuesandMortgage Terms?", Federal Reserve Board Finance and Economics Discussion Series, March. [9] Campbell John Y. and Joao F. Cocco. (2003). "Household Risk Management And Optimal Mortgage Choice," The Quarterly Journal of Economics 118, 1449-1494. [10] Dhillon, Upinder S., J.D. Shilling, and C.F. Sirmans. (1987). "Choosing Between Fixed and Adjustable Rate Mortgages," Journal of Money, Credit, and Banking 19, 260-267. [11] Fisher, Sarah and Susan Shelly. (2002). The Complete Idiot(cid:146)s Guide to Personal Finance in Your 20(cid:146)s and 30(cid:146)s, 2nd ed., Alpha Books, Indianapolis, IN. [12] Goodman, John L. (1982). "Linking Local Mobility Rates: Repeat Movers and Place E⁄ects." In Modeling Housing Market Search, edited by W.A.V. Clark. London: Croom Helm. [13] Nothaft, E. Frank and H.K. George Wang. (1992). "Determinants of the ARM Share of National and Regional Lending," Journal of Real Estate Finance and Economics, 5: 219-234. [14] Sa-aadu, J., and C.F. Sirmans (1995). "Di⁄erentiated Contracts, Heterogeneous Borrowers, and the Mortgage Choice Decision", Journal of Money, Credit and Banking, Vol. 27, No. 2. (May), 498-510. 14

[15] Smith J. Donald. (1987). The Borrower(cid:146)s Choice Between Fixed and Adjustable Rate Loan Contracts. AREUEA Journal 15:2 (Summer). [16] Statman, Meir. (1982). "Fixed Rate or Index-Linked Mortgages from the Borrower(cid:146)s Point of View: A Note," Journal of Financial and Quantitative Analysis 17 (Sept.), 451-457. [17] Stanton, Richard and Nancy Wallace. (1999). "Anatomy of an ARM: The Interest-Rate Risk of Adjustable-Rate Mortgages," Journal of Real Estate Finance and Economics 19, 49-67. [18] Tyson, Eric and Ray Brown. (2000). Mortgages for Dummies, Hungry Minds Inc., New York, NY. 15

Figure 1: Evolution of ARM Origination Share in SCF and MBA 40 35 30 MBA Index 25 20 15 SCF 10 5 0 1992 1994 1996 1998 2000 2002 2004 2006 16

Table 1: Summary Statistics of Datasets Variable Full sample More Risk Averse Less Risk Averse Frequency (Percent) ARM 14.6 14.1 15.6 Subprime mortgages 11.5 12.4 10.1 Overspending 12.4 12.7 11.7 Risk aversion 69.6 n.a. n.a. Stock Ownership 28.3 22.0 43.3 Married 76.8 76.6 77.3 College educated 48.5 42.6 61.5 White 82.0 80.1 85.0 Mean Age 43.5 44.4 41.4 Real initial mortgage balance 77,308 72,519 87,788 (cid:3) Mortgage length (years) 24.1 24.2 23.9 Mobility 15.2 14.7 16.2 Family size 3.0 3.0 3.1 Income volatility 92.8 96.0 86.0 Median (percent) Initial balance-to-income ratio 159.0 164.0 146.0 Total non-housing debt-to-income ratio 12.4 12.6 12.0 n.a.: not available (cid:3)Real values are in US dollars computed using 1982-84 prices 17

*NOITCNUF ECIOHC EGAGTROM EHT FO SETAMITSE TIGOL :2 elbaT esreva ksiR sseL esrevA ksiR eroM elpmaS lluF elbairaV oitar-sddO rrE .tS .feoc oitar-sddO rrE .tS .feoc oitar-sddO rrE .tS .feoc )01( )9( )8( )7( )6( )5( )4( )3( )2( 52.1 02.0 04.0 55.1 61.0 08.0 24.1 21.0 46.0 DAERPS (cid:3)(cid:3) (cid:3)(cid:3) (cid:3)(cid:3) 08.0 21.0 22.0- 76.0 01.0 14.0- 27.0 70.0 33.0- CY (cid:3)(cid:3) (cid:3)(cid:3) (cid:3)(cid:3) 73.0 12.0 99.0- 94.0 81.0 27.0- 44.0 31.0 38.0- MS (cid:3)(cid:3) (cid:3)(cid:3) (cid:3)(cid:3) 07.0 02.0 63.0- 08.0 61.0 22.0- 67.0 11.0 81.0- IFER (cid:3)(cid:3) (cid:3) (cid:3) 92.12 82.0 60.3 62.31 02.0 85.2 15.51 61.0 47.2 PBUS (cid:3)(cid:3) (cid:3)(cid:3) (cid:3)(cid:3) 51.1 03.0 41.0 93.1 32.0 33.0 72.1 81.0 32.0 DPSO (cid:3) (cid:3) 31.1 90.0 01.0 83.1 60.0 52.0 82.1 50.0 02.0 RIBM (cid:3)(cid:3) (cid:3)(cid:3) 01.1 62.0 92.0 89.0 52.0 80.0- 20.1 71.0 60.0 RIDT 51.1 03.0 35.0 70.1 82.0 42.0 01.1 02.0 63.0 BOM (cid:3)(cid:3) (cid:3)(cid:3) 67.0 21.0 72.0- KSIR (cid:3)(cid:3) 27.0 52.0 65.0- 16.0 61.0 56.0- 46.0 21.0 84.0- LOVCNI (cid:3)(cid:3) (cid:3)(cid:3) (cid:3)(cid:3) 94.1 02.0 04.0 94.1 61.0 04.0 94.1 31.0 93.0 KCOTS (cid:3)(cid:3) (cid:3)(cid:3) (cid:3)(cid:3) 77.1 52.0 75.0 14.1 61.0 43.0 05.1 41.0 04.0 CUDE (cid:3)(cid:3) (cid:3)(cid:3) (cid:3)(cid:3) 10.1 10.0 10.0 10.1 10.0 10.0 10.1 10.0 10.0 EGA (cid:3) (cid:3)(cid:3) 63.1 23.0 13.0 02.1 12.0 81.0 52.1 71.0 22.0 ECAR 89.0 70.0 20.0- 40.1 60.0 40.0 10.1 50.0 10.0 EZISMAF 51.1 82.0 41.0 42.1 42.0 12.0 02.1 81.0 81.0 SM 211,1 577,1 788,2 ezis elpmaS .ylevitcepser ,slevel tnecrep 5 dna tnecrep 01 eht ta ecnac(cid:133)ingis lacitsitats etacidni (cid:3)(cid:3) dna (cid:3) cirtemonoceruotahterusneotRIDTdnaRIBMfotnecrep1mottobdnapoteht⁄odemmirtevaheW :etoN .srorre tnemerusaem ro sreiltuo yb nevird ton si sisylana 18