Fixed-Rate Mortgages, Labor Markets, and Efficiency

The paper studies the effects of mortgage choices between fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs) on labor market efficiency. FRMs provide insurance for risk-averse borrowers in the sense that they pay the same rate over time and are not subject to uncertain spot market rates. FRMs, however, discourage borrowers from moving to other regions despite better employment opportunities, as they terminate the FRM contracts in order to move and their new loan interests may be higher. As FRM-borrowers do not move to other regions due to the interest lock-ins, entrepreneurs in other regions lose the potential surpluses from productive matches that would have occurred between borrowers-workers and entrepreneurs. Borrowers ignore this negative externality they impose on the entrepreneurs when choosing their mortgages, and too many borrowers choose FRMs relative to the efficient level. If FRMs are eliminated and ARM-insurance (that protects ARM-borrowers against uncertain adjustable interest rates) is created, it will improve efficiency. The paper also assesses quantitatively the welfare effects of eliminating FRMs and providing ARM-insurance.