Empirical Evidence on Mortgage Choice as a Screening Mechanism for Default Risk

This paper examines one of the most critical credit decisions made by consumers: selecting between a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM). This study employs a sample of 1,003 mortgage loans to empirically evaluate whether a borrower's choice between fixed and adjustable rate products is contingent upon both their transactions costs of default and default risk. The findings reveal that when a borrower's default costs are sufficiently small, high default risk borrowers disproportionately self-select into FRMs, while low default risk borrowers tend to selfselect into ARMs.