Modeling Mortgages with Prepayment Penalties
19 Pages Posted: 7 Jan 2013
Date Written: September 15, 2012
This paper uses a numerical simulation based on the Crank-Nicolson method to estimate the value of a fixed-rate mortgage (FRM) with embedded prepayment and non-defaultable options. We find that the value of the FRM will increase when interest rates decrease, increasing the incentive for borrowers to prepay the mortgage. This paper presents simulated results of prepayment penalties that may help financial institutions in enacting specific yield maintenance agreements and that may aid financial regulators in providing additional safety for financial lenders and borrowers.
Keywords: CIR Model, Crank-Nicolson, prepayment penalties, yield maintenance agreement
JEL Classification: G13, G21
Suggested Citation: Suggested Citation