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Lines of Credit and Consumption Smoothing: The Choice between Credit Cards and Home Equity Lines of Credit

Author

Listed:
  • Shubhasis Dey

Abstract

The 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.

Suggested Citation

  • Shubhasis Dey, 2005. "Lines of Credit and Consumption Smoothing: The Choice between Credit Cards and Home Equity Lines of Credit," Staff Working Papers 05-18, Bank of Canada.
  • Handle: RePEc:bca:bocawp:05-18
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    References listed on IDEAS

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    1. Glenn B. Canner & Thomas A. Durkin & Charles A. Luckett, 1998. "Recent developments in home equity lending," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Apr, pages 241-251.
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    3. Jensen, Helen H., 1985. "Home Equity Use and the Life Cycle Hypothesis," Staff General Research Papers Archive 11234, Iowa State University, Department of Economics.
    4. Calem, Paul S & Mester, Loretta J, 1995. "Consumer Behavior and the Stickiness of Credit-Card Interest Rates," American Economic Review, American Economic Association, vol. 85(5), pages 1327-1336, December.
    5. Glenn B. Canner & Charles A. Luckett, 1994. "Home equity lending: evidence from recent surveys," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jul, pages 571-583.
    6. Christopher D. Carroll, 1992. "The Buffer-Stock Theory of Saving: Some Macroeconomic Evidence," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 23(2), pages 61-156.
    7. Brito, Dagobert L & Hartley, Peter R, 1995. "Consumer Rationality and Credit Cards," Journal of Political Economy, University of Chicago Press, vol. 103(2), pages 400-433, April.
    8. Mester, Loretta J, 1994. "Why Are Credit Card Rates Sticky?," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 4(4), pages 505-530, May.
    9. Francesca Eugeni, 1993. "Consumer debt and home equity borrowing," Economic Perspectives, Federal Reserve Bank of Chicago, issue Mar, pages 2-13.
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    11. David B. Gross & Nicholas S. Souleles, 2002. "Do Liquidity Constraints and Interest Rates Matter for Consumer Behavior? Evidence from Credit Card Data," The Quarterly Journal of Economics, Oxford University Press, vol. 117(1), pages 149-185.
    12. Ausubel, Lawrence M, 1991. "The Failure of Competition in the Credit Card Market," American Economic Review, American Economic Association, vol. 81(1), pages 50-81, March.
    13. Glenn B. Canner & James T. Fergus & Charles A. Luckett, 1988. "Home equity lines of credit," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jun, pages 361-373.
    14. Shubhasis Dey & Gene Mumy, 2005. "Determinants of Borrowing Limits on Credit Cards," Staff Working Papers 05-7, Bank of Canada.
    15. Sangkyun Park, 1997. "Option value of credit lines as an explanation of high credit card rates," Research Paper 9702, Federal Reserve Bank of New York.
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    Cited by:

    1. Anne-Sophie Berger├Ęs & Philippe d'Astous & Georges Dionne, 2011. "Is there Any Dependence Between Consumer Credit Line Utilization and Default Probability on a Term Loan? Evidence from Bank-Level Data," Cahiers de recherche 1119, CIRPEE.
    2. Berger├Ęs, Anne-Sophie & d'Astous, Philippe & Dionne, Georges, 2015. "Is there any dependence between consumer credit line utilization and default probability on a term loan? Evidence from bank-customer data," Journal of Empirical Finance, Elsevier, vol. 33(C), pages 276-286.

    More about this item

    Keywords

    Credit and credit aggregates;

    JEL classification:

    • D1 - Microeconomics - - Household Behavior
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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