Tuesday, September 09, 2008

Megan McArdle doesn't like fixed rate mortgages.

She argues that because house prices are more volatile than interest rates, variable rate mortgages make more sense.

This argument makes no sense. The way to look at the issue is to consider households to be financial intermediaries. Financial intermediaries are most stable when their liabilities and assets have the same duration. Most households have two principal assets--their house, and their human capital. The house has long duration; the duration of jobs is variable. Fixed rate prepayable mortgages can have long duration, and because they have an embedded call option, the duration can be made variable.

Thus a prepayable fixed rate mortgage is a liability that matches well to a house's long duration and the owner's desire to have a free option to move to a new job. It helps stabilize household balance sheets.

3 comments:

Anonymous said...

Okay, but why is the home the primary savings vehicle? It is an inflation hedge, and citizens have lost faith in the dollar as a long term store of value.

Homes should be a place to live, and banks should be for saving. Subsidizing mortgage perks available no where else in the world is not good public policy. It just leads to speculation, and prices too high for the median person to afford. When the subsidies become too expensive to continue, well you can guess the rest...

rortybomb said...

I saw that argument too and it didn't make sense. She added to it in the comments, but even then I didn't follow it. I think she was arguing that flexible rates stabilize (decrease vol for) prices, but I didn't see much of a harder argument.

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