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Nominal mortgage contracts and the effects of inflation on portfolio allocation

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  • Joseph B. Nichols
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    Abstract

    Households who wish to extract home equity through refinancing their mortgage face a hidden transaction cost. The real value of the fixed nominal mortgage payment declines over time with inflation. The change in the real value of the mortgage payments from taking on a new mortgage is positive and an increasing function of inflation; higher inflation thus discourages households from re-balancing their portfolio as frequently as they would otherwise. The life cycle model developed in this paper demonstrates how the share of total wealth held in housing is sensitive to the rate of inflation, even when perfectly anticipated. Households hold larger positions in home equity earlier in the life cycle and smaller positions later in the life cycle as the rate of inflation increases.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2007-67.

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    Date of creation: 2007
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    Handle: RePEc:fip:fedgfe:2007-67

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    Keywords: Mortgage loans ; Households - Economic aspects;

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    1. Todd Sinai & Nicholas S. Souleles, 2005. "Owner-occupied housing as a hedge against rent risk," Working Papers 05-10, Federal Reserve Bank of Philadelphia.
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    9. Jesus Fernandez-Villaverde & Dirk Krueger, 2004. "Consumption and Saving over the Life Cycle: How Important are Consumer Durables?," 2004 Meeting Papers 357b, Society for Economic Dynamics.
    10. Marjorie Flavin & Takashi Yamashita, 2002. "Owner-Occupied Housing and the Composition of the Household Portfolio," American Economic Review, American Economic Association, vol. 92(1), pages 345-362, March.
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    12. Henderson, J Vernon & Ioannides, Yannis M, 1983. "A Model of Housing Tenure Choice," American Economic Review, American Economic Association, vol. 73(1), pages 98-113, March.
    13. Steven F. Venti & David A. Wise, 2000. "Aging and Housing Equity," NBER Working Papers 7882, National Bureau of Economic Research, Inc.
    14. Louise Sheiner & David N. Weil, 1992. "The Housing Wealth of the Aged," NBER Working Papers 4115, National Bureau of Economic Research, Inc.
    15. Rui Yao, 2005. "Optimal Consumption and Portfolio Choices with Risky Housing and Borrowing Constraints," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 197-239.
    16. Richard K. Green & Patric H. Hendershott, 1995. "Age, Housing Demand, and Real House Prices," Wisconsin-Madison CULER working papers 96-09, University of Wisconsin Center for Urban Land Economic Research.
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