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Optimal Mortgage Design

Tomasz Piskorski

Columbia Business School - Finance and Economics

Alexei Tchistyi

Haas School of Business, UC Berkeley

December 1, 2009

This paper studies optimal mortgage design in a continuous time setting with volatile and privately observable income, costly foreclosure, and a stochastic market interest rate. We show that the features of the optimal mortgage are consistent with an option adjustable-rate mortgage (option ARM). Under the optimal contract, the borrower is given discretion of how much to repay until his balance reaches a certain limit. The default rates and interest rate payment on the mortgage correlate positively with the market interest rate. Gains from using the optimal contract relative to simpler mortgages are the biggest for those who face more income variability, buy pricey houses given their income level or make little or no downpayment. Our model thus may help to explain a high concentration of option ARMs among riskier borrowers.

Number of Pages in PDF File: 52

Keywords: optimal mortgage design, dynamic security design, alternative mortgage products, option ARM

JEL Classification: G20, G21, G33

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Date posted: March 21, 2007 ; Last revised: August 20, 2011

Suggested Citation

Piskorski, Tomasz and Tchistyi, Alexei, Optimal Mortgage Design (December 1, 2009). Available at SSRN: http://ssrn.com/abstract=971223 or http://dx.doi.org/10.2139/ssrn.971223

Contact Information

Tomasz Piskorski
Columbia Business School - Finance and Economics ( email )
3022 Broadway
New York, NY 10027
United States

Alexei Tchistyi (Contact Author)
Haas School of Business, UC Berkeley ( email )
F602 Haas School of Business
University of California
Berkeley, CA 94720
United States
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References:  26
Citations:  23

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