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The demand for long-term mortgage contracts and the role of collateral

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  • Liu, Lu

    (The Wharton School, University of Pennsylvania)

Abstract

Long-term fixed-rate mortgage contracts protect households against interest rate risk, yet most countries have relatively short interest rate fixation lengths. Using administrative data from the UK, the paper finds that the choice of fixation length tracks the life-cycle decline of credit risk in the mortgage market: the loan-to-value (LTV) ratio decreases and collateral coverage improves over the life of the loan due to principal repayment and house price appreciation. High-LTV borrowers, who pay large initial credit spreads, trade off their insurance motive against reducing credit spreads over time using shorter-term contracts. To quantify demand for long-term contracts, I develop a life-cycle model of optimal mortgage fixation choice. With baseline house price growth and interest rate risk, households prefer shorter-term contracts at high LTV levels, and longer-term contracts once LTV is sufficiently low, in line with the data. The mechanism helps explain reduced and heterogeneous demand for long-term mortgage contracts.

Suggested Citation

  • Liu, Lu, 2023. "The demand for long-term mortgage contracts and the role of collateral," Bank of England working papers 1009, Bank of England.
    • Handle: RePEc:boe:boeewp:1009
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    More about this item

    Keywords

    Mortgage choice; house prices; credit risk; interest rate risk; household risk management; household finance.;
    All these keywords.

    JEL classification:

    • D15 - Microeconomics - - Household Behavior - - - Intertemporal Household Choice; Life Cycle Models and Saving
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G50 - Financial Economics - - Household Finance - - - General
    • G52 - Financial Economics - - Household Finance - - - Insurance

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