Mortgages as Recursive Contracts

FRB of San Francisco Working Paper No. 2003-03

44 Pages Posted: 25 May 2004

See all articles by John Krainer

John Krainer

Board of Governors of the Federal Reserve System

Milton H. Marquis

Florida State University - Department of Economics

Date Written: May 2003

Abstract

Mortgages are one-sided contracts under which the borrower may terminate the contract at any time, while the lender must commit to honoring the terms of the contract throughout its life. There are two aspects to this feature of the contract that are modeled in this paper. The first is that the borrower may choose between buying a house or renting. Given these alternatives, a contract between a household and a lender makes home ownership feasible, and provides insurance to the household against fluctuating rental payments. The second is that once in a contract, the household may terminate the contract by refinancing the future mortgage, and thus enter into a new contract. This option will be exercised whenever a combination of house price appreciation and declines in the mortgage rate is sufficient to increase the ex ante expected lifetime utility from the new versus the old contract.

Keywords: Mortgage loans, contracts

JEL Classification: E21, D91, G21

Suggested Citation

Krainer, John and Marquis, Milton H., Mortgages as Recursive Contracts (May 2003). FRB of San Francisco Working Paper No. 2003-03, Available at SSRN: https://ssrn.com/abstract=550285 or http://dx.doi.org/10.2139/ssrn.550285

John Krainer (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Milton H. Marquis

Florida State University - Department of Economics ( email )

Tallahassee, FL 30306-2180
United States

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