The Inefficiency of Refinancing: Why Prepayment Penalties are Good for Risky Borrowers

58 Pages Posted: 25 Mar 2008 Last revised: 6 Sep 2012

See all articles by Christopher J. Mayer

Christopher J. Mayer

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Tomasz Piskorski

Columbia Business School - Finance and Economics

Alexei Tchistyi

University of Illinois at Urbana-Champaign - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: November 28, 2010

Abstract

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

Mayer, Christopher J. and Piskorski, Tomasz and Tchistyi, Alexei, The Inefficiency of Refinancing: Why Prepayment Penalties are Good for Risky Borrowers (November 28, 2010). Available at SSRN: https://ssrn.com/abstract=1108528 or http://dx.doi.org/10.2139/ssrn.1108528

Christopher J. Mayer (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Tomasz Piskorski

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Alexei Tchistyi

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

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