Household Risk Management and Optimal Mortgage Choice

John Y. Campbell, Joao F. Cocco

NBER Working Paper No. 9759
Issued in June 2003
NBER Program(s):   EFG   ME   AP

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.

download in pdf format
   (580 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w9759

Published: John Y. Campbell & Joao F. Cocco, 2003. "Household Risk Management And Optimal Mortgage Choice," The Quarterly Journal of Economics, MIT Press, vol. 118(4), pages 1449-1494, November. citation courtesy of

Users who downloaded this paper also downloaded* these:
Calvet, Campbell, and Sodini w12030 Down or Out: Assessing the Welfare Costs of Household Investment Mistakes
Campbell w12149 Household Finance
Campbell and Cocco w11534 How Do House Prices Affect Consumption? Evidence From Micro Data
Doan, Litterman, and Sims w1202 Forecasting and Conditional Projection Using Realistic Prior Distributions
Campbell and Cocco w17516 A Model of Mortgage Default
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us