Rationality in Mortgage Choice Decisions

The primary goal of this paper has been to address the question of rationality and subjectivity in mortgage contract choice decisions. These decisions are important because the size of a mortgage and the financial features of a mortgage contract are suggested to have important implications for both the household’s welfare and the stability of the financial system. Thus far, most of the existing literature has focused upon normative implications for rational mortgage choice decisions, providing only the one direction in generating both theoretical foundations and informing specifications in existing empirical studies. What is missing in the mortgage market literature is that the underlying forces leading to risky and uninformed financial choices may not be explained solely by supply and demand factors, but should account for subjectivity and irrationality within suboptimal mortgage choice decisions. This paper addresses these questions and explores whether, in addition to the supply and demand side factors, subjective considerations may partially explain observed/ex-post mortgage type decisions. This is achieved by employing a theoretical model comprising of a two reduced form equations applying three stage least squares and maximum likelihood estimation techniques. For the first time, cross-sectional estimations utilise data extracted from the Understanding Society Survey Data for the newly originated mortgage contracts, covering the period from 2009 to 2014. This periodical frame covers the UK’s variable market share peak, which is also a period of changing mortgage lending conditions and introduction of financial literacy measures.Empirical results detect that subjective anticipation for the improvements in social status and expectations of better income increases likelihood of variable mortgage debt. Ability to take risks offers surprising results, suggesting that risk takers tend to prefer fixed rate mortgage options. The results also suggest that psychological reasons may explain why ARM borrowers tend to ignore the associated risk factors when choosing type of mortgage debt. The altering effect of time variation did not show significant results, empirically detecting persistent existence of the subjectivity in mortgage choice considerations. Policy implications may include development of training and financial literacy programs