Lines of Credit and Consumption Smoothing: The Choice between Credit Cards and Home Equity Lines of Credit
AbstractThe 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.
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Bibliographic InfoPaper provided by Bank of Canada in its series Working Papers with number 05-18.
Length: 26 pages
Date of creation: 2005
Date of revision:
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Credit and credit aggregates;
Find related papers by JEL classification:
- D1 - Microeconomics - - Household Behavior
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-07-18 (All new papers)
- NEP-BEC-2005-07-18 (Business Economics)
- NEP-DCM-2005-07-18 (Discrete Choice Models)
- NEP-FMK-2005-07-18 (Financial Markets)
- NEP-URE-2005-07-18 (Urban & Real Estate Economics)
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