Mortgage Choices in Equilibrium

This paper identifies the optimal mortgage choice of homeowners, who are subject to counter-cyclical income volatility and idiosyncratic income risk. The market equilibrium of investors with similar income risk exposures, leads to pro-cyclical equilibrium interest rates. The key determinant of the optimal mortgage choice is the correlation of income with the business cycle. Homeowners with high (low) correlation of income choose an ARM (FRM) and the more risk-averse homeowners are more likely to choose an ARM. Mortgage choices of homeowners have an impact on the financial market equilibrium, where interest rates become less volatile for larger shares of ARMs. I would like to thank Suleyman Basak, Peter O. Christensen, João Cocco, Fransisco Gomes, Christopher Hennessey, Ralph Koijen, and especially Linda S. Larsen for valuable comments which have contributed greatly to the analysis of this paper. I would also like to thank the participants at the seminars at London Business School, the University of Southern Denmark, and the Danish Financial Regulator for excellent discussions. Responsibility for any remaining errors is mine. †London Business School, Regents Park, London NW1 4SA, United Kingdom; [email protected].