Outstanding Debt and the Household Portfolio

This article examines the effect of household debt on investment decisions. We alter a simple portfolio choice model to allow households to retire outstanding debt and realize a risk-free rate of return equal to the interest rate on that debt. Using the Survey of Consumer Finances, we find that households with mortgage debt are 10% less likely to own stocks and 37% less likely to own bonds compared to similar households with no mortgage debt. We calculate the costs of nonoptimal investment in the presence of various forms of household debt. We find that 26% of households should forgo equity market participation on account of the high interest rates they pay on their debt. (JEL D03, D12, D14, G11, G12)