Mortgage Choice: What's the Point?
30 Pages Posted: 12 Jul 1995
Date Written: Undated
This paper develops a general equilibrium model of mortgage lending, combining self-selection theory with option pricing. We construct a separating equilibrium, in which lenders offer a menu of prepayable, fixed rate mortgage contracts, differing in their tradeoff between coupon rate and points (prepaid interest). Borrowers select the optimal contract from the menu, revealing their mobility via their choice of loan, and lenders make zero profit on each loan taken out. Such a separating equilibrium can only exist if borrowers face frictions, such as refinancing costs. Our model provides an explanation for the large menus of mortgages typically encountered by potential borrowers, as well as for the prepayment options that are embedded in mortgage contracts, despite the significant deadweight costs associated with refinancing. We also show that the recent proliferation of loans with many different horizons represents an alternative means of persuading borrowers to self-select, with lower deadweight costs. Finally, our model suggests that the menu of contracts available at the time of origination should be an important predictor of future prepayment. Most commonly used prepayment models, which do not take this into account, are therefore misspecified, leading to errors in pricing and hedging mortgages and mortgage-backed securities.
JEL Classification: G12, G13, G21
Suggested Citation: Suggested Citation