Household Risk Management and Optimal Mortgage ChoiceJohn Y. Campbell () and Joao F. Cocco No 1946, Harvard Institute of Economic Research Working Papers from Harvard - Institute of Economic Research Abstract: Home mortgages are the most significant financial contract for many households. The form of this contract is correspondingly important. This paper studies the choice between fixed-rate (FRM) and adjustable-rate (ARM) mortgages. In an environment with uncertain inflation, nominal FRMs have risky real capital value whereas ARMs have safe capital value. However ARMs can greatly increase the short-term variability of required real interest payments. This is a serious disadvantage of ARMs for households who face borrowing constraints and have only a small buffer stock of financial assets. The paper uses numerical methods to solve a life-cycle model with risky labor income and borrowing constraints, under alternative assumptions about available mortgage contracts. Households with large mortgages, risky labor income, high risk aversion, and a low probability of moving are more likely to prefer nominal FRMs. The paper also considers inflation-indexed FRMs. These mortgages remove the wealth risk of nominal FRMs without incurring the income risk of ARMs, and therefore are a superior vehicle for household risk management. The paper finds that the welfare gains of mortgage indexation can be very large. Date: Written 2002 Downloads: (external link) Related works: Access Statistics for this paper More papers in Harvard Institute of Economic Research Working Papers from Harvard - Institute of Economic Research |
Is your work missing from RePEc? Here is how to contribute.
Questions or problems? Check the EconPapers FAQ or send mail to .
Econpapers is hosted by the
Swedish Business School at Örebro University.