A Life-cycle Model with Housing, Portfolio Allocation, and Mortgage Financing

This paper presents a model developed to explain the life-cycle patterns in both homeownership and portfolio allocation, and the relationship between them, using a model of rational agents. Two key innovations are incorporated into this model. First, housing is explicitly modeled as both a consumption and investment good, as opposed to examining just one aspect in isolation from the other. Second, traditional mortgage contracts are also explicitly introduced into the model. A finite horizon life-cycle model including both of these innovations is then solved and calibrated using data from the Health and Retirement Survey. As a result, the model proves that the “over-investment” of housing is not inconsistent with the behavior of rational, forward-looking agents. The model is also able to capture the negative correlation between the housing share and risky asset share of portfolio. The results show how the desire to consume large homes contributes both to an increase in the portfolio share of housing and a decrease in the portfolio share of risky assets. This model demonstrates the close link between the housing “over-investment” and the stock “under-investment” puzzles