Household Leverage
32 Pages Posted: 19 Feb 2009
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Household Leverage
Date Written: February 15, 2009
Abstract
I propose a life-cycle model where a finitely lived risk averse agent finances his housing investment by a fixed rate mortgage contract. The agent is exposed to stochastic house price and stochastic labor income. After signing the mortgage contract, while increasing his equity share in the house through amortization, the agent optimally determines the time at which defaulting and moving into the rental market provides a greater expected continuation utility than continuing the mortgage payments. Lenders market efficiently price the mortgage, charging a default premium to compensate themselves for expected losses due to default on the mortgage. Three main results arise. First, the model predicts that the default premium is increasing in the volatility of house prices and decreasing in the down payment. Second, in order to justify a highly leveraged position in the house purchase whose price is highly volatile, the rent premium has to be substantial to make the agent ex ante indifferent between owning with a mortgage and renting the same house. Third, in the presence of borrowing constraints, a negative labor income shock induces the agent to early exercise his default option with a higher level of net wealth.
Keywords: household finance
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