The Value of Mortgage Choice: Payment Structure and Contract Length

We study how households choose between three mortgage contracts with different payment structures: fixed-rate fixed-payment, variable-rate variable-payment, and a hybrid variable-rate fixed-payment mortgage where interest rate changes affect principal repayment rather than payment size. This hybrid contract, which is offered in only a few countries around the world, gives households additional flexibility to insure against payment risk while exposing them to the risk of larger future mortgage balances. We model these mortgage types simultaneously and show that welfare is substantially improved when all three contracts are available for households to choose from. Our calibrated model matches mortgage choice patterns in Canada, where all these options are offered with short terms. We demonstrate that restricting contract choice or mandating long terms, as in the U.S. system, can lead to substantial welfare losses by limiting risk management strategies and increasing mortgage pricing ex-ante.