Abstract
In the presence of transaction costs, purchasers of housing services plan multi-year stays in specific locations by optimizing with regard to present and future preferences, incomes, and prices. In equilibrium, the sum over time of the weighted differences between the marginal rate of substitution and price ratio equals zero. This resembles a public good equilibrium, and the “Lindahl Solution” would call for borrowers to use variable payment mortgages. In this paper we fully develop the concept of an optimal mortgage by using a dynamic model in which transaction costs contrain mobility. We find that variable payment mortgages benefit consumers through reduced transaction costs and benefit the lender through a larger housing purchase earlier in life. A simulation is conducted to validate and quantify these theoretical findings with measures of equivalent and compensating variations. Impediments to Lindahl-type variable payment mortgages are discussed, and solutions are proposed.