Mortgage Type, Default Risk and Monetary Policy
Abstract: This paper investigates the effects of interest rate fluctuations on household mortgage decisions using a dynamic housing search model with defaultable long-term mortgages calibrated to the U.S. economy. The analysis evaluates market responses to three mortgage structures: 30-year fixed-rate, 30-year variable-rate, and 30-year fixed-rate with five-year renewals. The findings reveal that variable-rate and five-year renewable fixed-rate mortgages amplify the persistence of default rates and reduce household value as interest rates rise. The effect of each mortgage type depends on household leverage, with more pronounced differences observed during transitions from low to high interest rates. Market conditions also play a significant role, as these mortgage structures perform worse when calibrated to the Canadian economy, characterized by a higher mortgage debt-to-income ratio compared to the U.S. In contrast, the 30-year fixed-rate mortgage mitigates surges in default rates and prevents significant drops in household value. These findings underscore the importance of mortgage term design in enhancing economic resilience to interest rate volatility.