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Household Risk Management and Optimal Mortgage Choice

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  • John Y. Campbell
  • João F. Cocco

Abstract

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.

Suggested Citation

  • John Y. Campbell & João F. Cocco, 2003. "Household Risk Management and Optimal Mortgage Choice," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 118(4), pages 1449-1494.
    • Handle: RePEc:oup:qjecon:v:118:y:2003:i:4:p:1449-1494.
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    File URL: http://hdl.handle.net/10.1162/003355303322552847
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    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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