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Improving Risk Sharing and Borrower Incentives in Mortgage Design

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  • Yuchen Mei
  • Phelim Boyle
  • Johnny Siu-Hang Li

Abstract

In a traditional fixed rate mortgage, the borrower pays a fixed amount each period regardless of the value of the mortgaged property. One problem with this contract is that the borrower is less willing to pay when the house value falls. This was clearly seen in the 2008 financial crisis and its aftermath when mortgage default rates and foreclosures skyrocketed as the housing market crashed. A more efficient contract design should link payments to house prices so that the borrower’s incentive to pay is not undermined by a decline in property value. In addition, this design can save the lender the deadweight foreclosure costs. In this article, we examine two proposed index linked mortgages that have this risk sharing feature. We analyze the effect of both designs on borrower incentives in a multiperiod setting.

Suggested Citation

  • Yuchen Mei & Phelim Boyle & Johnny Siu-Hang Li, 2019. "Improving Risk Sharing and Borrower Incentives in Mortgage Design," North American Actuarial Journal, Taylor & Francis Journals, vol. 23(4), pages 485-511, October.
    • Handle: RePEc:taf:uaajxx:v:23:y:2019:i:4:p:485-511
    DOI: 10.1080/10920277.2019.1634594
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