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Household Risk Management and Optimal Mortgage Choice

John Campbell () and Joao F. Cocco

No 9759, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: A typical household has a home mortgage as its most significant financial contract. The form of this contract is correspondingly important. This paper studies the choice between a fixed-rate (FRM) and an adjustable-rate (ARM) mortgage. In an environment with uncertain inflation, a nominal FRM has risky real capital value whereas an ARM has a stable real capital value. However an ARM can increase the short-term variability of required real interest payments. This is a disadvantage of the ARM for a household that faces borrowing constraints and has 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. While an ARM is generally an attractive form of mortgage, a household with a large mortgage, risky labor income, high risk aversion, a high cost of default, and a low probability of moving is less likely to prefer an ARM. The paper also considers an inflation-indexed FRM, which removes the wealth risk of the nominal FRM without incurring the income risk of the ARM, and is therefore a superior vehicle for household risk management. The welfare gain from mortgage indexation can be very large.

JEL-codes: G1 E4 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn and nep-ure
Date: 2003-06
Note: EFG ME AP
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Published as John Y. Campbell & Joao F. Cocco, 2003. "Household Risk Management And Optimal Mortgage Choice," The Quarterly Journal of Economics, MIT Press, vol. 118(4), pages 1449-1494, November.

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Working Paper: Household Risk Management and Optimal Mortgage Choice (2004) Downloads
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Working Paper: Household Risk Management and Optimal Mortgage Choice (2003) Downloads
Working Paper: Household Risk Management and Optimal Mortgage Choice (2002) Downloads
Working Paper: Household Risk Management and Optimal Mortgage Choice (2002)
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