Lines of Credit and Consumption Smoothing: The Choice between Credit Cards and Home Equity Lines of Credit

Shubhasis Dey ()

Staff Working Papers from Bank of Canada

Abstract: The author models the choice between credit cards and home equity lines of credit (HELOCs) within a framework where consumers hold lines of credit as instruments of consumption smoothing across state and time. Flexible repayment schemes for lines of credit induce risk-averse consumers with sufficiently high discount rates to underinsure and hold lines of credit instead as a buffer, even when they have access to full and fair insurance markets. Weighing the fixed upfront fees and higher default costs of HELOCs against the advantages of low and income-tax-deductible interest payments, the author finds a threshold level of potential borrowing belowwhich consumers prefer to use credit cards exclusively. Above that threshold, consumers decide touse HELOCs and consolidate all outstanding credit card debt into them; however, a rising probability of default and the resulting loss of equity in the home will put an upper bound on the potential HELOC borrowing that will prevent full debt consolidation.

Keywords: Credit; and; credit; aggregates (search for similar items in EconPapers)
JEL-codes: D1 D81 (search for similar items in EconPapers)
Pages: 26 pages
Date: 2005
New Economics Papers: this item is included in nep-bec, nep-dcm, nep-fmk and nep-ure
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:05-18

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