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Household Risk Management and Optimal Mortgage Choice

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  • Joao Cocco
  • John Campbell

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.
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Suggested Citation

  • Joao Cocco & John Campbell, 2004. "Household Risk Management and Optimal Mortgage Choice," Econometric Society 2004 North American Winter Meetings 632, Econometric Society.
    • Handle: RePEc:ecm:nawm04:632
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    File URL: http://repec.org/esNAWM04/up.18800.1052807478.pdf
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