Working Paper: NBER ID: w9759
Authors: John Y. Campbell; Joao F. Cocco
Abstract: A typical household has a home mortgage as its most significant financial contract. The form of this contract is correspondingly important. This paper studies the choice between a fixed-rate (FRM) and an adjustable-rate (ARM) mortgage. In an environment with uncertain inflation, a nominal FRM has risky real capital value whereas an ARM has a stable real capital value. However an ARM can increase the short-term variability of required real interest payments. This is a disadvantage of the ARM for a household that faces borrowing constraints and has only a small buffer stock of financial assets. The paper uses numerical methods to solve a life-cycle model with risky labor income and borrowing constraints, under alternative assumptions about available mortgage contracts. While an ARM is generally an attractive form of mortgage, a household with a large mortgage, risky labor income, high risk aversion, a high cost of default, and a low probability of moving is less likely to prefer an ARM. The paper also considers an inflation-indexed FRM, which removes the wealth risk of the nominal FRM without incurring the income risk of the ARM, and is therefore a superior vehicle for household risk management. The welfare gain from mortgage indexation can be very large.
Keywords: mortgage choice; household risk management; fixed-rate mortgage; adjustable-rate mortgage; inflation-indexed mortgage
JEL Codes: G1; E4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Mortgage Type (G21) | Household Risk (D14) |
| Labor Income Risk and Constraints (J29) | Mortgage Choice (G21) |
| Income Volatility (E25) | Mortgage Preference (G51) |
| Inflation-Indexed FRM (E43) | Risk Mitigation (D81) |
| Mobility and Savings (J62) | Mortgage Choice (G21) |