Pricing Mortgages: Endogenous Interest Rate and Leverage
42 Pages Posted: 4 Mar 2016
Date Written: February 2016
Mortgages are priced alone two dimensions – the interest rate and the leverage. This paper develops a simple model of a mortgage contract, in which differences in the borrower and the lender’s risk preference jointly determine the equilibrium interest rate and leverage. This model provides novel predictions, including counter-cyclical leverage of real estate: loan to value ratios of newly generated mortgages should be higher when property values are lower. Co-integration tests on commercial mortgage data provide generally supporting evidence for the predictions, and the evidence on counter-cyclical leverage is very strong both statistically and economically.
Keywords: mortgage, interest rate, financial leverage, commercial real estate
JEL Classification: G12, G21, E32, E44
Suggested Citation: Suggested Citation