DP16634 Breaking the Commitment Device: The Effect of Home Equity Withdrawal on Consumption, Saving, and Welfare

Author(s): Agnes Kovacs, Patrick Moran
Publication Date: October 2021
Date Revised: October 2021
Keyword(s): commitment, Euler Equation, Household consumption, Mortgage Design
JEL(s): D15, E21, E71, G28, G51
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16634

This paper investigates the macroeconomic and welfare implications of permitting home equity withdrawal. We evaluate the trade-off between two opposing views: the benefit of improved consumption smoothing and the potential cost of weakened commitment. To disentangle their relative importance, we estimate a life-cycle model containing both channels. We find that the welfare cost of weakened commitment is substantial: approximately 1.7 times larger than the benefit of improved consumption smoothing. Both channels contribute equally to a 2.5 percentage point reduction in the personal saving rate. Welfare could be improved using state-contingent mortgages that better balance the trade-off between flexibility and commitment.