Lines of Credit and Consumption Smoothing

Abstract

Lines of credit (LOCs) are widely used by consumers. Here, we try to understand the major motives of such prevalent use. We model LOCs as instruments of consumption smoothing across states and time periods. A fundamental feature of insurance contracts is that insurance premiums are payable at the beginning of every period and in all the states of the world. We find that consumers who are impatient can use LOCs as substitutes for full and fair insurance contracts. This provides an explanation for endogenously incomplete insurance markets. Even when consumers perfectly smooth out their consumption every period across all the states of the world with insurance contracts alone, LOCs may be useful for smoothing out consumption across time periods and for pure transactions purposes. Our model can also explain an apparently puzzling consumer behavior of simultaneously saving and carrying over LOC debt, because the observed LOC debt here could be due to the realization of the wealth risks for which consumers optimally hold less than fully covering insurance contracts.