One of the most important features of the mortgage contract is the repayment schedule. Traditionally, most mortgages force the borrower to gradually repay the mortgage and build wealth in the form of home equity. During recent decades, however, financial innovation has created a wide variety of alternative mortgage products that allow households to delay mortgage repayment (Cocco, 2013). Perhaps the most famous example is the interest-only mortgage, which became popular in the mid-2000s, jumping to roughly 25 percent of mortgage originations in the United States prior to the 2008 financial crisis (Amromin et al., 2018). Such mortgage contracts remain popular in many European countries and, in recent years, have seen increased interest as governments try to address the recent increase in the cost-of-living. Recent research shows that interest-only mortgages reduce monthly payments but also result in less wealth accumulation due to delayed mortgage repayment (Bernstein and Koudijs, 2023). Further, many commentators have suggested a close link between interest-only mortgages and rising mortgage debt (see, for instance, the New York Times article, How Countrywide Covered the Cracks).
Impact of interest-only mortgages on household borrowing
Despite the important role of the repayment schedule, we have little evidence of how this key feature of the mortgage contract affects household borrowing. There are at least two contrasting views. On the one hand, interest-only mortgages relax credit constraints, helping constrained households to borrow when they expect income or house prices to grow (Piskorski and Tchistyi, 2010; Cocco, 2013). On the other hand, many commentators have suggested that consumers may suffer from behavioral biases that lead them to increase borrowing due to low initial payments. According to this theory, constrained and unconstrained consumers may both prioritize a low monthly payment, which is highly salient, rather than minimize the net present value of future interest payments (Argyle et al., 2020). While we already have clear evidence on the first mechanism, we know little about the latter.
In a recent paper, we investigate the role of behavioral biases that may affect mortgage choice above and beyond the standard economic factors, such as credit constraints. More specifically, we exploit a policy reform in Sweden that eliminated interest-only mortgages for borrowers with loan-to-value (LTV) ratios above 50 percent. In the data, we find that many homebuyers make larger down payments following the reform, while existing borrowers extract less equity.
Figure 1 shows the distribution of loan-to-value ratios at the time of mortgage origination during the years before and after the policy reform in 2016. The three top panels show the distribution prior to the reform, while the three bottom panels show the distribution after policy implementation. Following the reform, many households cut their borrowing to obtain an LTV ratio of exactly 50 percent, allowing them to qualify for an interest-only mortgage. Using a difference-in-bunching estimator, we find that borrowers reduce their LTV ratios by 5 percent in response to a one percentage point higher average amortization rate, indicating that mandatory mortgage repayment lead to lower borrowing.
