Household Risk Management and Optimal Mortgage Choice

John 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: 2002
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Citations: View citations in EconPapers (3)

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Related works:
Working Paper: Household Risk Management and Optimal Mortgage Choice (2004)
Working Paper: Household Risk Management and Optimal Mortgage Choice (2004)
Journal Article: Household Risk Management and Optimal Mortgage Choice (2003)
Working Paper: Household Risk Management and Optimal Mortgage Choice (2003)
Working Paper: Household Risk Management and Optimal Mortgage Choice (2003)
Working Paper: Household Risk Management and Optimal Mortgage Choice (2002)
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