Department of Finance
Date of this Version
2-2-2004
Abstract
Executive Summary
• The usual advice given to the public by financial planners and the popular press is that less debt is better and in particular owning your own house outright is a desirable goal.
• We show that this advice is often wrong because mortgage debt acts as an inflation hedge. Mortgage debt also has a valuable refinancing option in case interest rates fall and an abandonment option if the value of the property declines.
• Mortgage debt is often seen simply as necessary because of people’s limited financial assets. Specifically, people can purchase a home only if they resort to borrowing. Employing a numerical model, we demonstrate that some level of mortgage debt is valuable to many individuals who do not face such a constraint.
• The model is able to simulate over a wide range of plausible assumptions the impact of mortgage debt on a household’s wealth. Home ownership provides households a hedge against rental increases, but exposes them to the vagaries of the local real estate market. Our model shows that mortgage debt allows individuals to hedge against inflation and local market risk.
• The model allows an analyst to vary assumptions to examine the impact of the mortgage decision on a particular household.
Comments
Published online in Social Science Research Network @ http://papers.ssrn.co/sol3/papers.cfm?abstract_id=499064 Copyright © 2004 D. Dudney, M. peterson, & T. Zorn. Used by permission.