Drivers of Mortgage Choices by Risky Borrowers

Drivers of Mortgage Choices by Risky Borrowers
Fred Furlong, David Lang, and Yelena Takhtamanova
FRBSF Economic Letter 2014-01 January 6, 2014

 

 

EXCERPT:

During the past decade’s housing boom, borrowers with lower credit ratings were more likely than higher-rated borrowers to choose adjustable-rate mortgages. This raises the question of whether, amid rapidly rising house prices, lower-rated borrowers paid less attention to loan pricing and interest-rate-related factors. However, even accounting for house price appreciation, research shows these borrowers were as, if not more, responsive as higher-rated borrowers to changes in interest-rate-related fundamentals. Their tendency to choose adjustable-rate mortgages is consistent with mortgage decisions based on economic considerations, rather than just lack of financial sophistication.

When the housing market collapsed in the past decade, mortgage delinquencies and foreclosures swelled. Borrowers with lower credit ratings were hit particularly hard. During the housing boom, these riskier borrowers had increased access to mortgage financing and were more likely to choose adjustable-rate mortgages than their counterparts with higher credit ratings. Some observers argue that this tendency to choose adjustable-rate financing and the subsequent higher default rates show that this group was less financially sophisticated than borrowers with higher credit ratings.

In this Economic Letter, we consider what factors influenced the mortgage choices of lower-credit-rated borrowers. In general, rising house prices made borrowers at all risk levels less sensitive to loan pricing and other interest-rate-related fundamentals (Furlong and Takhtamanova 2012). However, even accounting for house price appreciation, we find that lower-rated borrowers were at least as sensitive to changes in fundamentals as higher-rated borrowers, if not more so. This suggests that lower-rated borrowers chose adjustable-rate mortgages for economic reasons, not merely because they may have been less financially sophisticated than other borrowers.

 

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