TY  - JOUR
AU  - Campbell,John Y.
AU  - Cocco,Joao F.
TI  - Household Risk Management and Optimal Mortgage Choice
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 9759
PY  - 2003
Y2  - June 2003
UR  - http://www.nber.org/papers/w9759
L1  - http://www.nber.org/papers/w9759.pdf
N1  - Author contact info:
John Y. Campbell
Morton L. and Carole S.
Olshan Professor of Economics
Department of Economics
Harvard University
Littauer Center 213
Cambridge, MA 02138
Tel: 617/496-6448
Fax: 617/495-7730
E-Mail: john_campbell@harvard.edu

Joao Cocco
London Business School
Regent's Park
London NW1 4SA, UK
E-Mail: jcocco@london.edu
AB  - 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.
ER  -