Several factors, including economic conditions weigh heavily on borrowers who choose adjustable rate loans versus fixed rate loans, finds an economic letter by the San Francisco Federal Reserve Bank’s Fred Furlong, David Lang, and Yelena Takhtamanova.
The research finds a propensity among borrowers with low credit scores to choose adjustable rate mortgages during the housing downturn, but that this decision had more to do with the economy than with lack of financial sophistication.
Overall, borrowers with financial constraints tend toward adjustable rate mortgages rather than fixed rate mortgages, the researchers note, in part due to having less to lose in a situation where default occurs.
“We have noted that borrowers with financial constraints or lower risk aversion tend to favor ARMs,” they write. “People with lower incomes tend to be more financially constrained and have lower credit ratings. Thus, borrowers with lower credit ratings typically are more financially constrained and more likely to choose ARMs.”
Additionally, borrowers who choose adjustable rate mortgages are less likely to understand the risks involved, they note, which can also impact borrower sensitivity to interest-rate fundamentals.
Ultimately, however, the researchers conclude that an inclination toward adjustable rate loans in the past several years had more to do with the housing market than other factors.
“During the housing boom, rising prices dampened the influence of interest rate fundamentals on borrower mortgage choice. That was especially true for borrowers with lower credit ratings, who showed a greater tendency to choose adjustable-rate mortgages,” Furlong, Land and Takhtamanova write. “Yet, when house prices rose rapidly, those borrowers responded at least as strongly as higher-rated borrowers to changes in fundamentals. This suggests that the greater propensity of low FICO borrowers to choose ARMs is more consistent with mortgage choice reflecting economic considerations rather than lack of financial sophistication among low FICO borrowers.”
Written by Elizabeth Ecker