This paper studies how borrowers with different levels of default risk would self-select between fixed rate mortgages (FRMs) and adjustable rate mortgages (ARMs). We show that under asymmetric information, where the risk type of a borrower is private information to the borrower and not known by the lender, the unique equilibrium may be a separating equilibrium in which the high-risk (low-risk) borrowers choose ARMs (FRM's). Thus, the borrower's mortgage choice will serve as a signal of default risk, enabling lenders to screen high-risk and low-risk borrowers. It is possible for the separating equilibrium to yield positive economic profits for lenders in a competitive market. It is also possible to have a unique pooling equilibrium where all borrowers choose either FRMs or ARMs. The model implies that an increase in the proportion of high risks will increase the likelihood of a separating equilibrium where both mortgage types are offered. Also, a uniform downward shift in the expected change in the interest rate or an increase in borrowers' current or future incomes make ARMs more attractive for both types of borrowers.
All Science Journal Classification (ASJC) codes
- Economics and Econometrics
- Urban Studies