James R. Follain

The Rise and Fall of the ARM: An Econometric Analysis of Mortgage Choice

This paper estimates an empirical model of the choice between adjustable- and fixe d-rate mortgages using a large national database compiled by the Nat ional Association of Realtors. The explanatory variables in the probi t choice equation include borrower characteristics, regional dummies, the FRM rate, and the FRM-ARM rate differential. Since the intrerest rate on the mortgage not chosen is unobserved, this rate must be est imated in a way that eliminates selectivity bias. Simulation of the e stimated choice equation provides insight into the origin of the ARM revolution. Copyright 1988 by MIT Press.

Alternative Mortgage Instruments, the Tilt Problem, and Consumer Welfare

The Standard Fixed Payment Mortgage (SFPM) has been the dominant mortgage instrument in the United States for the last 50 years, and for much of this period it has performed well. However, during periods of high and volatile rates of inflation, the SFPM suffers from severe weaknesses. Foremost among these problems, from the standpoint of the borrower, is the tilt in the stream of real mortgage payments toward the initial years of the mortgage. For consumers unconstrained by capital market imperfections, this tilt is unimportant. However, a consumer is typically unable to borrow against expected higher future income, or against the nominal capital gains that accrue to the owner of a house over the life of the mortgage. In addition, common practices of mortgage lenders often limit mortgage payments to some fraction of income at the time of purchase. Together, these liquidity constraints create a mismatch between the time sequence of mortgage payments and income, a mismatch that reduces the number of borrowers who qualify for financing and that limits the value of the house purchased by those who do obtain financing.

Microfoundations of a Mortgage Prepayment Function

This article focuses on the following question: how much of an interest rate decline is needed to justify refinancing a typical home mortgage? Modern option pricing theory is used to answer the question; this theory indicates that the answer depends upon several factors, which include the volatility of interest rates and the expected holding period of the borrower. The analysis suggests that the commonly espoused “rule of thumb” refinance if the interest rate declines by 200 basis points — is a fair approximation to the more precisely derived differential for many households. We also construct the prepayment behavior of a pool of mortgages in which the expected holding periods of the borrowers in the pool vary. The prepayment behavior of this simulated pool is used to generate a series of empirically testable hypotheses regarding the likely shape of an actual prepayment function and its determinants. Finally, actual prepayment data are used to estimate a hazard function that explains prepayment behavior. We find that the estimated model understates prepayment behavior relative to that predicted by the simulation model, which suggests that the simple option pricing model is not adequate to explain aggregate prepayment behavior.

Another Look at Racial Differences in Housing Prices

The existence of segregated housing has sparked interest in the question of whether blacks pay more for housing. That racial segregation exists is not in doubt. The effect of segregation on housing prices in black versus white submarkets is less clear. The empirical evidence is not conclusive. Past studies have yielded disparate results because they applied different models to one or a few markets. In addition earlier studies often used data from samples taken a decade or more ago, while evidence exists that submarket price differentials change significantly over time. This paper presents estimates of racial submarket price differentials in 39 large Standard Metropolitan Statistical Areas (SMSAs). The household level data used are from the Annual Housing Survey, and are both recent (1974-76 data) and extensive (700 to 2,000 degrees of freedom in each of 78 regressions). Separate equations are estimated for owners and renters. The same two models, based on the method of hedonic equations, are employed in every SMSA. We find that in most markets blacks pay less for comparable housing than non-blacks. The average discount for blacks is about 15 per cent for owners and 6 per cent for renters. We also find, as expected, that variation does exist in the estimate for the differential among metropolitan areas.

Another Look at Tenure Choice, Inflation, and Taxes

The purpose of this paper is to explore the impact of inflation on the demand for housing. The first part of the paper presents a theoretical model that identifies the effects of inflation on the after-tax cost of housing and the choice between rental and owner-occupied housing. The second part discusses the results of a simulation model that measures the effect of inflation on the aggregate demand for housing, the aggregate homeownership rate, and the price of housing. The paper concludes that while inflation can be expected to increase the aggregate demand for housing and the price of housing relative to the general price level, inflation should ultimately lead to lower rates of homeownership. A corollary that is probably more relevant today is that lower inflation rates should reduce the real value of the housing stock and increase the homeownership rate. The paper also contains forecasts of the impact of the Tax Reform Act (TRA) of 1986 upon housing demand and the probability of homeownership for a variety of households. Copyright American Real Estate and Urban Economics Association.

Tax-Induced Portfolio Reshuffling: The Case of the Mortgage Interest Deduction

Several provisions of the Tax Reform Act of 1986 had an indirect impact upon the demand for home mortgage debt. These include the elimination of the deductibility of interest on consumer credit, the increase in the standard deduction, and the reduction in the number of expenses that can be itemized. These provisions and the 1983-1989 panel sample of the Survey of Consumer Finances provide an opportunity to study the responsiveness of the demand for home mortgage debt to its tax status relative to the tax treatment of equity-financed investments in housing and consumer credit. The results are strongly supportive of a highly elastic demand for mortgage debt with respect to its tax price. The best point estimate of this elasticity is -1, but substantial variation is found among certain groups. More generally, the results provide strong support for the phenomenon of portfolio reshuffling. Copyright American Real Estate and Urban Economics Association.

The preferential income tax treatment of owner‐occupied housing: Who really benefits?

Abstract This article uses a model that includes an explicit measure of net implicit rental income to examine the size and distribution of the tax expenditure to owner‐occupied housing across and within homeowner income classes. The model is derived from 1989 American Housing Survey data. The analysis leads to three major conclusions. First, on net, the inclusion of net implicit income in the measure of homeowner tax savings adds a substantial amount to the estimated tax expenditure given to owner‐occupied housing. Second, the interaction of changes in the standard deduction and in the tax treatment of itemized nonhousing expenses has rendered the mortgage interest deduction worthless for many low‐ and moderate‐income households. Third, although most of the expenditure is distributed to high‐income households, the distributional effects of eliminating the expenditure to owner‐occupied housing depend on the manner in which these savings are distributed.

ARMs and the demand for housing

Abstract This paper estimates the effect of a borrowers mortgage type (ARM or FRM) on housing demand. A two-stage procedure is used wherein a probit mortgage choice equation is first estimated and predicted choice probabilities from this equation are then used to modify the choice-dependent interest-cost measures in the demand equation (the modified equation is then consistently estimated by OLS). The empirical results give answers to the following questions: Do ARM borrowers consider future ARM rates in formulating their housing demands? Are the housing demands of ARM borrowers more or less sensitive than those of FRM borrowers to an increase in the (initial) mortgage rate? Do ARM borrowers demand more or less housing than FRM borrowers at typical interest rates? What is the effect on aggregate housing demand of changes in the ARM share over the interest-rate cycle?

Housing crowding in developing countries and willingness to pay for additional space: The case of Korea☆

The very rapid rate of urban population growth in developing countries is placing great strain on their housing stock. Housing policies which aim at reducing or eliminating crowding are generally based on notions of needs and standards of adequacy which are more often based on arbitrarily selected criteria than on domestic economic conditions. This paper attempts to evaluate the willingness to pay for additional housing space by households and the validity of target housing standards. The paper uses three different estimation procedures, each with its own strengths and conceptual limitations, to determine whether they yield consistent estimates of household willingness to pay for space. They show consistently that the willingness to pay for additional space is less than 25 percent of the value of an extra unit of space, everything else being equal.

The flight to the suburbs: Insights gained from an analysis of central-city vs suburban housing costs

n The central thesis of this paper is that the prices people pay for housing can be used to determine whether the movement of population to the suburbs is caused primarily by attraction to suburban advantages or by the desire to escape deteriorating conditions in the central city. Estimates of the coefficients indicating the price of central city versus suburban housing in the United States are presented and analyzed using a regression model.n