Interest rate risk and optimal design of mortgage instruments

This article develops and analyzes a simple expected utility model for interest rate risk and mortgage choice. The model demonstrates how the risks of interest rate changes should be allocated between borrowers and lenders through varying mortgage payments. In general, we conclude that full protection against interest rate risk, as a normative guideline, is likely to be suboptimal for the typical household. Our results show that the optimal design of adjustable rate mortgages should include an interest rate CAP provision.An earlier version of this article was presented at the American Real Estate and Urban Economics Association Meetings, Atlanta, Georgia, December 27–30, 1989.