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Optimal mortgage contracts with time-inconsistent preferences

Author

Listed:
  • Wenqiong Liu
  • Wenli Huang
  • Bo Liu
  • Congming Mu

Abstract

This paper integrates a time-inconsistent preference into the mortgage design problem and studies the corresponding effects on the optimal contract. By assuming exogenous time inconsistency in borrower's preference, we find that the time-inconsistent preference increases the loss in the lender's value and the compensation boundary. We implement the optimal contract using standard securities and option adjustable-rate mortgages (ARMs). The findings show that the time-inconsistent preference increases the default rate, and relative to standard securities, option ARMs increase the total debt capacity, but the borrower's time inconsistency can lead to sudden jumps in the total debt capacity. We also consider the endogenous time inconsistency in the borrower's preference and derive the corresponding mortgage contract; we find that a lender can perfectly offset the effect of a borrower's time inconsistency on the value function and compensation strategy. The liquidation boundary at the low interest rate varies with the degree of time inconsistency, explaining the heterogeneity in mortgage default behaviors observed in practice.

Suggested Citation

  • Wenqiong Liu & Wenli Huang & Bo Liu & Congming Mu, 2019. "Optimal mortgage contracts with time-inconsistent preferences," The European Journal of Finance, Taylor & Francis Journals, vol. 25(18), pages 1834-1855, December.
    • Handle: RePEc:taf:eurjfi:v:25:y:2019:i:18:p:1834-1855
    DOI: 10.1080/1351847X.2019.1649290
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    Cited by:

    1. Pengfei Luo & Zhaojun Yang, 2021. "Investment and financing for cash flow discounted with group diversity," International Review of Finance, International Review of Finance Ltd., vol. 21(3), pages 769-785, September.
    2. Camilo Hern'andez & Dylan Possamai, 2023. "Time-inconsistent contract theory," Papers 2303.01601, arXiv.org.

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