Adjustable and Fixed Rate Mortgages as a Screening Mechanism for Default Risk

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.