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Dynamic portfolio and mortgage choice for homeowners

  • Otto van Hemert
  • Franck de Jong
  • Joost Driessen
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    We investigate the impact of owner-occupied housing on financial portfolio and mortgage choice under stochastic inflation and real interest rates. To this end we develop a dynamic framework in which investors can invest in stocks and bonds with different maturities. We use a continuous-time model with CRRA preferences and calibrate the model parameters using data on inflation rates and equity, bond, and house prices. For the case of no short-sale constraints, we derive an implicit solution and identify the main channels through which the housing to total wealth ratio and the horizon affect financial portfolio choice. This solution is used to interpret numerical results that we provide when the investor has short-sale constraints. We also use our framework to investigate optimal mortgage size and type. A moderately risk-averse investor prefers an adjustable-rate mortgage (ARM), while a more risk-averse investor prefers a fixedrate mortgage (FRM). A combination of an ARM and an FRM further improves welfare. Choosing a suboptimal mortgage leads to utility losses up to 6%.

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    File URL: http://eprints.lse.ac.uk/24650/
    File Function: Open access version.
    Download Restriction: no

    Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24650.

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    Length: 38 pages
    Date of creation: 15 May 2005
    Date of revision:
    Handle: RePEc:ehl:lserod:24650
    Contact details of provider: Postal: LSE Library Portugal Street London, WC2A 2HD, U.K.
    Phone: +44 (020) 7405 7686
    Web page: http://www.lse.ac.uk/

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    1. Miquel Faig & Pauline Shum, 2002. "Portfolio Choice in the Presence of Personal Illiquid Projects," Journal of Finance, American Finance Association, vol. 57(1), pages 303-328, 02.
    2. Viceira, Luis & Campbell, John, 2001. "Who Should Buy Long-Term Bonds?," Scholarly Articles 3128709, Harvard University Department of Economics.
    3. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04.
    4. John Y. Campbell & Joao F. Cocco, 2003. "Household Risk Management and Optimal Mortgage Choice," NBER Working Papers 9759, National Bureau of Economic Research, Inc.
    5. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, March.
    6. Sanford J. Grossman & Guy Laroque, 1987. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," NBER Working Papers 2369, National Bureau of Economic Research, Inc.
    7. 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.
    8. John Heaton & Deborah Lucas, 2000. "Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk," Journal of Finance, American Finance Association, vol. 55(3), pages 1163-1198, 06.
    9. Brueckner, Jan K, 1997. "Consumption and Investment Motives and the Portfolio Choices of Homeowners," The Journal of Real Estate Finance and Economics, Springer, vol. 15(2), pages 159-80, October.
    10. 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.
    11. Michael J. Brennan & Yihong Xia, 2002. "Dynamic Asset Allocation under Inflation," Journal of Finance, American Finance Association, vol. 57(3), pages 1201-1238, 06.
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