Household Risk Management and Optimal Mortgage Choice

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Household Risk Management and Optimal Mortgage Choice

Home mortgages are the most significant financial contract for many households. The form of this contract is correspondingly important. This paper studies the choice between fixed-rate (FRM) and adjustable-rate (ARM) mortgages. In an environment with uncertain inflation, nominal FRMs have risky real capital value whereas ARMs have safe capital value. However ARMs can greatly increase the short-term variability of required real interest payments. This is a serious disadvantage of ARMs for households who face borrowing constraints and have 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. Households with large mortgages, risky labor income, high risk aversion, and a low probability of moving are more likely to prefer nominal FRMs. The paper also considers inflation-indexed FRMs. These mortgages remove the wealth risk of nominal FRMs without incurring the income risk of ARMs, and therefore are a superior vehicle for household risk management. The paper finds that the welfare gains of mortgage indexation can be very large.

Household Risk Management and Optimal Mortgage Choice

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.

How Do House Prices Affect Consumption? Evidence From Micro F. Data

Housing is a major component of wealth. Since house prices fluctuate considerably over time, it is important to understand how these fluctuations affect households’ consumption decisions. Rising house prices may stimulate consumption by increasing households’ perceived wealth, or by relaxing borrowing constraints. This paper investigates the response of household consumption to house prices using UK micro data. We estimate the largest effect of house prices on consumption for older homeowners, and the smallest effect, insignificantly different from zero, for younger renters. This finding is consistent with heterogeneity in the wealth effect across these groups. It suggests that as the population ages and becomes more concentrated in the old homeowners group, aggregate consumption may become more responsive to house prices. In addition, we find that regional house prices affect regional consumption growth. Predictable changes in house prices are correlated with predictable changes in consumption, particularly for households that are more likely to be borrowing constrained, but this effect is driven by national rather than regional house prices and is important for renters as well as homeowners, suggesting that UK house prices are correlated with aggregate financial market conditions.

How Do House Prices Affect Consumption? Evidence from Micro Data

Housing is a major component of wealth. Since house prices fluctuate considerably over time, it is important to understand how these fluctuations affect households’ consumption decisions. Rising house prices may stimulate consumption by increasing households’ perceived wealth, or by relaxing borrowing constraints. This paper investigates the response of household consumption to house prices using UK micro data. We estimate the largest effect of house prices on consumption for older homeowners, and the smallest effect, insignificantly different from zero, for younger renters. This finding is consistent with heterogeneity in the wealth effect across these groups. In addition, we find that regional house prices affect regional consumption growth. Predictable changes in house prices are correlated with predictable changes in consumption, particularly for households that are more likely to be borrowing constrained, but this effect is driven by national rather than regional house prices and is important for renters as well as homeowners, suggesting that UK house prices are correlated with aggregate financial market conditions.Economic

Household Risk Management and Optimal Mortgage Choice

This paper asks how a household should choose between a fixed-rate (FRM) and an adjustable-rate (ARM) mortgage. In an environment with uncertain inflation a nominal FRM has a risky real capital value, whereas an ARM has a stable real capital value but short-term variability in required real payments. Numerical solution of a life-cycle model with borrowing constraints and income risk shows that an ARM is generally attractive, but less so for a risk-averse household with a large mortgage, risky income, high default cost, or low moving probability. An inflation-indexed FRM can improve substantially on standard nominal mortgages.Economic

Aging in place, housing maintenance and reverse mortgages

We study the role of housing wealth in financing retirement consumption. In our model retirees: 1. derive utility benefits from remaining in their home (aging in place); and 2. choose in each period whether to maintain their house. The evidence that we present shows that these features are important in explaining the saving decisions of the elderly. The costs and the maintenance requirement of reverse mortgages (RMs) reduce (or eliminate) the benefits of the loans for retirees who wish to do less maintenance. We evaluate the impact of different loan features on retirees’ utility, cash-flows to lenders, and to the government agency that provides mortgage insurance. We show that combining RMs with insurance against a forced home sale (e.g. due to a move to a nursing home) is Pareto improving and can lead to increased demand for the loans due to product complementarities

A Model of Mortgage Default

In this paper, we solve a dynamic model of households' mortgage decisions incorporating labor income, house price, inflation, and interest rate risk. Using a zero-profit condition for mortgage lenders, we solve for equilibrium mortgage rates given borrower characteristics and optimal decisions. The model quantifies the effects of adjustable versus fixed mortgage rates, loan-to-value ratios, and mortgage affordability measures on mortgage premia and default. Mortgage selection by heterogeneous borrowers helps explain the higher default rates on adjustable-rate mortgages during the recent U.S. housing downturn, and the variation in mortgage premia with the level of interest rates.Economic

Stock Market Mean Reversion and the Optimal Equity Allocation of a Long-Lived Investor

This paper solves numerically the intertemporal consumption and portfolio choice problem of an infinitely-lived investor who faces a time-varying equity premium. The solutions we obtain are very similar to the approximate analytical solutions of Campbell and Viceira (1999), except at the upper extreme of the state space where both the numerical consumption and portfolio rules flatten out. We also consider a constrained version of the problem in which the investor faces borrowing and short-sales restrictions. These constraints bind when the equity premium moves away from its mean in either direction, and are particularly severe for risk-tolerant investors. The constraints have substantial effects on optimal consumption, but much more modest effects on optimal portfolio choice in the region of the state space where they are not binding.Economic

Investing Retirement Wealth: A Life-Cycle Model

If household portfolios are constrained by borrowing and short-sales restrictions asset markets, then alternative retirement savings systems may affect household welfare by relaxing these constraints. This paper uses a calibrated partial-equilibrium model of optimal life-cycle portfolio choice to explore the empirical relevance of these issues. In a benchmark case, we find ex-ante welfare gains equivalent to a 3.7% increase in consumption from the investment of half of retirement wealth in the equity market. The main channel through which these gains are realized is that the higher average return on equities permits a lower Social Security tax rate on younger households, which helps households smooth their consumption over the life cycle. There is a smaller welfare gain of 0.5% of consumption when Social Security tax rates are held constant. We also find that realistic heterogeneity of risk aversion and labor income risk can strongly affect optimal portfolio choice over the life cycle, which provides one argument for a privatized Social Security system with an element of personal portfolio choice.