ARMs and the demand for housing

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Abstract

This paper estimates the effect of a borrower's mortgage type (ARM or FRM) on housing demand. A two-stage procedure is used wherein a probit mortgage choice equation is first estimated and predicted choice probabilities from this equation are then used to modify the choice-dependent interest-cost measures in the demand equation (the modified equation is then consistently estimated by OLS). The empirical results give answers to the following questions: Do ARM borrowers consider future ARM rates in formulating their housing demands? Are the housing demands of ARM borrowers more or less sensitive than those of FRM borrowers to an increase in the (initial) mortgage rate? Do ARM borrowers demand more or less housing than FRM borrowers at typical interest rates? What is the effect on aggregate housing demand of changes in the ARM share over the interest-rate cycle?

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This research was conducted while Follain was a member of the Department of Finance at the University of Illinois. We gratefully acknowledge financial support from the Office of Real Estate Research at the University of Illinois. Also, we wish to thank Anil Bera, Roger Koenker, and the NBER conference participants (especially Patric Hendershott, James Kau, and N. Gregory Mankiw) for helpful comments. We also thank the National Association of Realtors (especially Forest Pafenberg) for providing the data used in this study. Errors, of course, are ours.

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