Abstract
Borrowers in U.S. cities where house prices boomed in the 2000s relied heavily on backloaded interest-only (IO) mortgages that require borrowers to only pay interest for the first few years of the loan. We develop a theory that encompasses common explanations for IO use, and show that while they can account for much of the regional variation in IOs, they cannot explain why IOs were popular in boom cities. We propose a new explanation. In our model, uncertain price appreciation coupled with non-recourse lending can lead to speculation financed with backloaded mortgages. We find evidence that IO borrowers behaved in ways consistent with such speculation, and discuss the policy implications of our findings.
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