Journal of Risk

Risk.net

Well ARMed and FiRM: diversification of mortgage loans for homebuyers

Kourosh M. Rasmussen and Stavros A. Zenios

ABSTRACT

Individual homebuyers today are offered a wide range of mortgage options for financing the purchase of a house. Usually, homebuyers 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 homebuyer’s situation warrants it. While, traditionally, a single mortgage loan would serve borrower needs, today it appears that a portfolio of loans may satisfy the mortgage needs of the individual and their appetite for risk much better. In this paper we develop a model for the diversification of mortgage loans of a homebuyer and apply it to data from the Danish market. Even in the presence of mortgage origination costs, it is shown that most risk-averse homebuyers will do well to consider a diversified portfolio of both fixed- and adjustable-rate mortgages (FRM and ARM). This is particularly the case if one takes, unavoidably, a long-term perspective in financing the purchase of a home through a mortgage loan.

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