Interest Rate Risk, Term Spreads, and the Mortgage Contract Term

Abstract

Borrowers of a mortgage can choose between fully bearing the interest rate chance risk and paying a term spread to be protected against fluctuating mortgage rates. By using a one-period model, we study the choice between a fully adjustable mortgage and a fully fixed-rate mortgage. Furthermore, we examine with a life cycle model whether a mortgage is best broken down into several shortto-medium-term FRMs -a common form in various mortgage markets but only rarely analyzed in research. We are among the first to demonstrate that borrowers with high risk aversion, nonamortizing mortgages, a large mortgage, and a low probability of moving are better off with long-term contracts. Our results show that amortizing mortgages are best broken down into several contracts with the optimal contract term generally declining as the mortgage ages. Initial contracts may be shorter than following contracts, only if borrowers expect to benefit from decreasing interest rates.For non-amortizing mortgages, a fully FRM is superior, unless interest rates are expected to decrease significantly.