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Dynamic portfolio and mortgage choice for homeowners

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  • Hemert, Otto van
  • Jong, Franck de
  • Driessen, Joost

Abstract

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%.

Suggested Citation

  • Hemert, Otto van & Jong, Franck de & Driessen, Joost, 2005. "Dynamic portfolio and mortgage choice for homeowners," LSE Research Online Documents on Economics 24650, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:24650
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    References listed on IDEAS

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    Cited by:

    1. Devine, Kenneth & McCarthy, Yvonne & O’Toole, Conor, 2023. "The role of borrower expectations in mortgage choice," Journal of Behavioral and Experimental Economics (formerly The Journal of Socio-Economics), Elsevier, vol. 107(C).
    2. de Jong, Frank, 2008. "Pension fund investments and the valuation of liabilities under conditional indexation," Insurance: Mathematics and Economics, Elsevier, vol. 42(1), pages 1-13, February.
    3. De Jong, Frank, 2008. "Valuation of pension liabilities in incomplete markets," Journal of Pension Economics and Finance, Cambridge University Press, vol. 7(3), pages 277-294, November.
    4. Sumit Agarwal & Brent W. Ambrose, 2008. "Does it pay to read your junk mail? evidence of the effect of advertising on home equity credit choices," Working Paper Series WP-08-09, Federal Reserve Bank of Chicago.

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    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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