Household Interest Rate Risk Management

I investigate household interest rate risk management by solving a life-cycle asset allocation model that includes mortgage and bond portfolio choice. I find that most investors prefer an adjustable-rate mortgage and thereby save on the bond risk premium that is contained in fixed-rate mortgage payments. Only older, risk-averse investors hold some fixed-rate mortgage debt. Together with a position in short-term bonds this enables them to hedge against changes in the real interest rate, while the inflation exposure of the debt and bond positions cancel out. Hedging house price changes with bonds only occurs at the end of the life cycle. Early in the life cycle short-sale constraints prevent an effective hedge.