Why mortgage structure is a hidden driver of financial risk

[UNITED STATES] As central banks confront the long tail of inflation with tighter monetary policy, a less visible question lurks in the background: how much does mortgage structure dictate who bears the risk—and when? A new academic paper argues that the design of mortgage contracts plays a decisive but underappreciated role in shaping financial stability across regions. The research, by Wharton’s Lu Liu and Johns Hopkins’s Vadim Elenev, uses a calibrated model to show how interest rate shifts reverberate through households and banks differently depending on whether mortgages are fixed- or adjustable-rate—and, crucially, how long the rate remains fixed. The takeaway is clear: mortgage structure is not just a consumer finance detail. It’s a macro lever. And it’s one that US policymakers may need to rethink sooner rather than later.

Context: The Mortgage Design Gap in a Rate-Volatile World

The global economy is still digesting the aftershocks of the most aggressive interest rate hikes in over a decade. Yet the effects of these rate hikes haven’t been uniform. The United States—with its 30-year fixed-rate mortgage (FRM) standard—has seen households insulated from rising payments, while banks have absorbed mark-to-market losses on long-duration assets. In contrast, markets like Canada and the UK, which lean heavily on adjustable-rate mortgages (ARMs) or short fixation periods, have seen borrowers take the hit more directly—through rising monthly payments and, in some cases, surging default risk.

This divergence isn’t anecdotal. Liu and Elenev’s paper, Mortgage Structure, Financial Stability, and Risk Sharing, models this phenomenon systematically. Their findings illustrate how ARMs shift rate risk onto borrowers, while FRMs push that same volatility into banks’ balance sheets. Both come with tradeoffs: ARMs generate income for banks during rate hikes but stress household budgets; FRMs offer stability for homeowners but expose lenders to capital erosion as rates rise and asset values fall.

As Liu notes, “In the most recent interest-rate tightening cycle, there has been a common, global rise in rates, but it has had very different ramifications... depending on the mortgage structure.”

Strategic Comparison: Why a Binary Choice Misses the Point
The conventional wisdom tends to treat FRMs as pro-consumer and ARMs as bank-friendly, with policy leaning accordingly. But the real insight from Liu and Elenev’s model is this: the optimal mortgage design may lie somewhere in between. Their simulations suggest that mortgages with an “intermediate fixation length”—between three and five years—can better balance macro-level risk-sharing. Such structures reduce the volatility of banks’ net worth while avoiding sharp payment resets that destabilize households.

This echoes lessons from past cycles. Consider the post-2008 experience: the US mortgage market leaned too far into securitized FRMs, which looked stable at first but transmitted rate risk into systemic bank fragility. Meanwhile, UK and Canadian systems leaned on ARMs, exposing households to repayment shocks when policy rates rose sharply. Each model worked under low-rate conditions—but began to fray once macro volatility returned.

There’s also a timing dimension here. ARMs, according to the authors, concentrate defaults when bank capital is strong—thus minimizing systemic contagion. Meanwhile, FRMs defer risk, locking households into low rates but potentially inflating asset prices or freezing mobility. The so-called “mortgage lock-in” effect—where homeowners don’t move or refinance because they hold below-market rates—has arguably distorted the US housing market post-COVID.

Even more compelling is how these dynamics interact with deposit behavior. Banks with FRM portfolios may benefit from deposit “stickiness,” earning stable spreads. But when interest rates rise rapidly, those same FRMs underperform, eating into capital cushions. In contrast, ARM-heavy lenders see profits rise in sync with rates—up to the point of borrower distress. “Your income will be very volatile,” Liu notes, “depending on where interest rates go.”

Implication: Why Policy Design Must Catch Up to Macro Reality

If mortgage structure acts as a transmission channel for monetary policy, it also becomes a potential lever for macroprudential design. The implication for US regulators and central bankers is clear: it may be time to reconsider the dominance of the 30-year FRM. While that model has helped households plan with certainty, it may now be blunting the effectiveness of rate hikes—while simultaneously exposing lenders to creeping balance sheet risk.

Liu is careful not to prescribe policy. Yet the timing of her research speaks volumes. With inflation still persistent and rate volatility a live risk, the US housing finance system could face structural stress—not through subprime blowups, but through duration mismatches and capital erosion in bank portfolios.

Policymakers may need to explore hybrid models that retain the predictability of FRMs while allowing more dynamic risk distribution. Intermediate fixation terms—three to five years—could become a new norm, particularly if paired with macroprudential buffers and borrower protections.

Moreover, as the Federal Reserve navigates a longer path of elevated rates, understanding how mortgage structure amplifies—or dampens—policy transmission will become increasingly urgent. Simply put, monetary policy effectiveness is not rate-level dependent alone; it’s design-contingent.

Our Viewpoint

Mortgage structure is no longer just a microeconomic detail. It’s a system-level variable with real consequences for financial stability, monetary policy transmission, and market resilience. The traditional fixed vs adjustable dichotomy is too simplistic for a macro environment defined by volatility, sticky inflation, and nonlinear rate effects. The Liu-Elenev research offers a timely reminder: the form of a mortgage isn’t neutral—it shapes where, when, and how financial pain is distributed. In a world where central banks must stay agile, policymakers can no longer afford to ignore the architecture of lending contracts. Mortgage design is monetary policy infrastructure—and it’s overdue for an upgrade.