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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/27408
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| Title: | Optimal Mortgage Design |
| Authors: | Piskorski, Tomasz
Tchistyi, Alexei |
| Issue Date: | 20-Nov-2006 |
| Series/Report no.: | FIN-07-056 |
| Abstract: | This paper studies optimal mortgage design. A borrower (a household)
with limited liability needs financial support from a lender (a big
financial institution) to purchase a home. We characterize the optimal
allocation in a continuous time setting in which (i) the borrower s
income is volatile and its realization is unobservable to the lender,
(ii) the lender has a right to costly foreclose the loan and seize the
house, (iii) the borrower s intertemporal consumption preferences are
represented by a constant discount factor, (iv) the lender discounts
cash ows using a stochastic discount factor that depends on the market
interest rate. We show that the optimal allocation can be implemented
using either a combination of an interest only mortgage with a home
equity line of credit or an option adjustable rate mortgage. Under the
optimal contracts, mortgage payments and default rates are higher when
the market interest rate is high. However, borrowers benefit from low
mortgage payments and low default rates when the market interest rate is
low. Thus, our analysis provides theoretical evidence that these
alternative mortgages, which have recently generated great controversy,
can benefit both lenders and borrowers. |
| URI: | http://hdl.handle.net/2451/27408 |
| Appears in Collections: | Finance Working Papers
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