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Household Risk Management and Optimal Mortgage Choice

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Author Info
John Y. Campbell
Joao F. Cocco

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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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9759.

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Date of creation: Jun 2003
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Handle: RePEc:nbr:nberwo:9759

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G1 - Financial Economics - - General Financial Markets
E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

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