Empirical Evidence on Mortgage Choice as a Screening Mechanism for Default Risk

Abstract

This paper examines one of the most critical credit decisions made by consumers:selecting between a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM).This study employs a sample of 1,003 mortgage loans to empirically evaluate whether aborrower's choice between fixed and adjustable rate products is contingent upon boththeir transactions costs of default and default risk. The findings reveal that when aborrower's default costs are sufficiently small, high default risk borrowersdisproportionately self-select into FRMs, while low default risk borrowers tend to selfselectinto ARMs.