Declining Mortgage Prepayment Penalties and the Value of Delay

24 Pages Posted: 18 Nov 1999

See all articles by Austin Kelly

Austin Kelly

Federal Housing Finance Agency (FHFA)

V. Carlos Slawson, Jr.

Louisiana State University

Date Written: August 27, 1999

Abstract

Mortgages are complicated instruments, and the pace of financial innovation complicates them further. Unlike standard single family mortgages, the terms on commercial loans are heterogeneous, and the motivations of property owners are not well understood. Single family lenders are increasingly adopting the prepayment penalties found in the commercial market. This paper fills in a gap in the study of mortgage finance by determining the optimal refinancing strategy under common forms of prepayment penalties. Our paper uses a bivariate binomial options pricing technique to value call options within various mortgages with different types of prepayment penalties. Using simulations, we calculate the spread between contract and prevailing interest rates needed to trigger an optimal refinance, and find that it is often substantially larger for mortgages with declining penalties than for mortgages with static penalties. The larger required spreads caused by the enhanced value of delay explain much of the slow prepayment behavior discovered in the multifamily market by Follain, Ondrich, and Sinha (1997). Therefore, borrower decisions which appear slow (or irrational) in a static setting may be quite rational in a dynamic setting.

Our results have important implications for both the interpretation of regression results based on historical data, and for the pricing of newly originated mortgages. Declining prepayment penalties were used extensively for multifamily mortgages in the 1970's and 1980's. While their use has declined in the 1990's in favor of yield maintainance agreements, empirical studies which use 1970's and 1980's data need to incorporate the effects of these penalty structures or risk specification bias. At the same time that their use is declining in the multifamily market it is growing in the single-family market. Understanding the behavior of these mortgages will be crucial to their pricing.

JEL Classification: G21

Suggested Citation

Kelly, Austin J. and Slawson, Jr., V. Carlos, Declining Mortgage Prepayment Penalties and the Value of Delay (August 27, 1999). Available at SSRN: https://ssrn.com/abstract=178270 or http://dx.doi.org/10.2139/ssrn.178270

Austin J. Kelly (Contact Author)

Federal Housing Finance Agency (FHFA) ( email )

1700 G St. NW
Washington, DC 20552
United States
202 414-1336 (Phone)

V. Carlos Slawson, Jr.

Louisiana State University ( email )

E. J. Ourso College of Business
Department of Finance
Baton Rouge, LA 70803-6308
United States
225-578-6291 (Phone)

HOME PAGE: http://www.lsu.edu/business/finance/profile-viewer.php?un=cslawson

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