Mortgage Design in an Equilibrium Model of the Housing Market

70 Pages Posted: 26 Mar 2018 Last revised: 18 Apr 2022

See all articles by Adam M. Guren

Adam M. Guren

Boston University - Department of Economics

Arvind Krishnamurthy

Stanford Graduate School of Business

Timothy McQuade

Stanford University

Date Written: March 2018


How can mortgages be redesigned to reduce housing market volatility, consumption volatility, and default? How does mortgage design interact with monetary policy? We answer these questions using a quantitative equilibrium life cycle model with aggregate shocks, long-term mortgages, and an equilibrium housing market, focusing on designs that index payments to monetary policy. Designs that raise mortgage payments in booms and lower them in recessions do better than designs with fixed mortgage payments. The benefits are quantitatively substantial: In a simulated crisis under a monetary regime in which the central bank lowers real interest rates in a bust, house prices fall 2.24 percentage points less, 23 percent fewer households default, and consumption falls by 0.79 percentage points less with ARMs relative to FRMs. Among designs that reduce payments in a bust, we show that those that front-load the payment reductions and concentrate them in recessions outperform designs that spread payment reductions over the life of the mortgage. Front-loading alleviates household liquidity constraints in states where they are most binding, reducing default and stimulating housing demand by new homeowners. To isolate this channel, we compare an FRM with a built-in option to be converted to an ARM with an FRM with an option to be refinanced at the prevailing FRM rate. Under these two contracts, the present value of a lender's loan falls by roughly an equal amount, but the FRM that can be converted to an ARM, which front loads payment reductions, reduces the declines in prices and consumption six times as much, and reduces default three times as much.

Suggested Citation

Guren, Adam M. and Krishnamurthy, Arvind and McQuade, Timothy, Mortgage Design in an Equilibrium Model of the Housing Market (March 2018). NBER Working Paper No. w24446, Available at SSRN:

Adam M. Guren (Contact Author)

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States


Arvind Krishnamurthy

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Timothy McQuade

Stanford University ( email )

Stanford, CA 94305
United States

Do you want regular updates from SSRN on Twitter?

Paper statistics

Abstract Views
PlumX Metrics