Well ARMed and FiRM:Diversification of mortgage loans for homeowners

Abstract

Individual homeowners are offered today a wide range of mortgage options for financing the purchase of a house. Usually, homeowners are also granted an option to repay the mortgage loan, and in some countries - such as Denmark - it is particularly efficient to do so as market conditions change or the homeowner's situation warrants it. And while, traditionally, a single mortgage loan would serve borrower needs, today it appears that a portfolio of loans may satisfy much better the mortgage needs of the individual and his or her appetite for risk. In this paper we develop a model for the diversification of mortgage loans of a homeowner and apply it to data from the Danish market. Even in the presence of mortgage origination costs it is shown that most risk averse homeowners will do well to consider a diversified portfolio of both fixed (FRM) and adjustable (ARM) rate mortgages. This is particularly so if one takes, unavoidably, a long term perspective in financing the purchase of a home through a mortgage loan.