The Demand for Long-Term Mortgage Contracts and the Role of Collateral - Lu Liu
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Finance
Speaker : Lu Liu (Wharton)
Long-term fixed-rate mortgage contracts protect households against interest rate risk, yet most countries have short fixation lengths, up to five years. Using administrative data from the UK, this paper shows that the choice of fixation length is affected by the life-cycle dimension of credit risk in the mortgage market: the loan-to-value (LTV) ratio declines and collateral coverage improves over the life of the loan due to principal repayment and house price appreciation. High-LTV borrowers face a trade-off between their demand to insure against repricing and obtaining lower credit spreads over time using shorter-term contracts. To quantify demand for longer-term contracts, I develop a life-cycle model of optimal mortgage fixation choice. With baseline house price growth and interest rate risk, high-LTV households prefer shorter-term contracts, in line with the data.