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

54 Pages Posted: 6 Dec 2010

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: December 2010

Abstract

This paper explores the practice of mortgage refinancing in a dynamic competitive lending model with risky borrowers and costly default. We show that prepayment penalties improve welfare by ensuring longer-term lending contracts, which prevents the mortgage pools from becoming disproportionately composed of the riskiest borrowers over time. Mortgages with prepayment penalties allow lenders to lower mortgage rates and extend credit to the least creditworthy, with the largest benefits going to the riskiest borrowers, who have the most incentive to refinance in response to positive credit shocks. Empirical evidence from more than 21,000 non-agency securitized fixed rate mortgages is consistent with the key predictions of our model. Our results suggest that regulations banning refinancing penalties might have the unintended consequence of restricting access to credit and raising rates for the least creditworthy borrowers.

Suggested Citation

Mayer, Christopher J. and Piskorski, Tomasz and Tchistyi, Alexei, The Inefficiency of Refinancing: Why Prepayment Penalties are Good for Risky Borrowers (December 2010). NBER Working Paper No. w16586. Available at SSRN: https://ssrn.com/abstract=1719946

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

Register to save articles to
your library

Register

Paper statistics

Downloads
48
Abstract Views
800
PlumX Metrics