The Inefficiency of Refinancing: Why Prepayment Penalties are Good for Risky Borrowers
58 Pages Posted: 25 Mar 2008 Last revised: 6 Sep 2012
Date Written: November 28, 2010
This paper provides a theoretical analysis of the efficiency of prepayment penalties in a dynamic competitive lending model with risky borrowers and costly default. When considering improvements in the borrower's creditworthiness as one of the reasons for refinancing mortgages, we show that refinancing penalties can be welfare improving, and that they can be particularly beneficial to riskier borrowers in the form of lower mortgage rates, reduced defaults, and increased availability of credit. Thus, a high concentration of prepayment penalties among the riskiest borrowers can be an outcome of efficient equilibrium in a mortgage market. We also provide empirical evidence that is consistent with the key predictions of our model.
Keywords: Inefficiency of refinancing, prepayment penalties, risky borrowers, mortgages
JEL Classification: G20, G21, G33
Suggested Citation: Suggested Citation