Borrowing Costs and the Demand for Equity over the Life Cycle Borrowing Costs and the Demand for Equity over the Life Cycle

By Steven J. Davis, Felix Kubler, and Paul Willen

We construct a life-cycle model that delivers realistic behavior for both equity holdings and borrowings. The key model ingredient is a wedge between the cost of borrowing and the risk-free investment return. Borrowing can either raise or lower equity demand, depending on the cost of borrowing. A borrowing rate equal to the expected return on equity — which we show roughly matches the data — minimizes the demand for equity. Alternative models with no borrowing or limited borrowing at the risk-free rate cannot simultaneously fit empirical evidence on borrowing and equity holdings.