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Optimal Mortgage Refinancing: A Closed Form Solution

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  • Sumit Agarwal
  • John C. Driscoll
  • David Laibson

Abstract

We derive the first closed-form optimal mortgage refinancing rule. The expression is derived by using the Lambert-W function to solve a tractable class of mortgage refinancing problems. We calibrate our solution and show that our quantitative results closely match those reported by researchers who use numerical methods.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13487.

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Date of creation: Oct 2007
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Handle: RePEc:nbr:nberwo:13487

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  1. Xavier Gabaix & Arvind Krishnamurthy & Olivier Vigneron, 2007. "Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market," Journal of Finance, American Finance Association, vol. 62(2), pages 557-595, 04.
  2. Bennett, Paul & Peach, Richard & Peristiani, Stavros, 2001. "Structural Change in the Mortgage Market and the Propensity to Refinance," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(4), pages 955-75, November.
  3. Campbell, John, 2006. "Household Finance," Scholarly Articles 3157877, Harvard University Department of Economics.
  4. Li, Minqiang & Pearson, Neil D. & Poteshman, Allen M., 2004. "Conditional estimation of diffusion processes," Journal of Financial Economics, Elsevier, vol. 74(1), pages 31-66, October.
  5. Follain, James R & Scott, Louis O & Yang, T L Tyler, 1992. "Microfoundations of a Mortgage Prepayment Function," The Journal of Real Estate Finance and Economics, Springer, vol. 5(2), pages 197-217, June.
  6. Andrew H. Chen & David C. Ling, 1989. "Optimal Mortgage Refinancing with Stochastic Interest Rates," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 17(3), pages 278-299.
  7. Quigley, John M, 1987. "Interest Rate Variations, Mortgage Prepayments and Household Mobility," The Review of Economics and Statistics, MIT Press, vol. 69(4), pages 636-43, November.
  8. Dunn, Kenneth B & McConnell, John J, 1981. "Valuation of GNMA Mortgage-Backed Securities," Journal of Finance, American Finance Association, vol. 36(3), pages 599-616, June.
  9. Chris Downing & Richard Stanton & Nancy Wallace, 2005. "An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 33(4), pages 681-710, December.
  10. Jerry Green & John B. Shoven, 1983. "The Effects of Interest Rates on Mortgage Prepayments," NBER Working Papers 1246, National Bureau of Economic Research, Inc.
  11. Gabaix, Xavier & Laibson, David I., 2006. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," Scholarly Articles 4554333, Harvard University Department of Economics.
  12. Yan Chang & Abdullah Yavas, 2009. "Do Borrowers Make Rational Choices on Points and Refinancing?," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 37(4), pages 635-658.
  13. Wayne R. Archer & David C. Ling, 1993. "Pricing Mortgage-Backed Securities: Integrating Optimal Call and Empirical Models of Prepayment," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 21(4), pages 373-404.
  14. Yongheng Deng & John M. Quigley & Robert Van Order, 2000. "Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options," Econometrica, Econometric Society, vol. 68(2), pages 275-308, March.
  15. Hurst, Erik & Stafford, Frank, 2004. "Home Is Where the Equity Is: Mortgage Refinancing and Household Consumption," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(6), pages 985-1014, December.
  16. Paul Bennett & Richard Peach & Stavros Peristiani, 1998. "Implied mortgage refinancing thresholds," Staff Reports 49, Federal Reserve Bank of New York.
  17. Giliberto, S Michael & Thibodeau, Thomas G, 1989. "Modeling Conventional Residential Mortgage Refinancings," The Journal of Real Estate Finance and Economics, Springer, vol. 2(4), pages 285-99, December.
  18. Schwartz, Eduardo S & Torous, Walter N, 1992. "Prepayment, Default, and the Valuation of Mortgage Pass-through Securities," The Journal of Business, University of Chicago Press, vol. 65(2), pages 221-39, April.
  19. Kenneth B. Dunn & Chester S. Spatt, 2005. "The Effect of Refinancing Costs and Market Imperfections on the Optimal Call Strategy and the Pricing of Debt Contracts," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 33(4), pages 595-617, December.
  20. Caplin, Andrew & Freeman, Charles & Tracy, Joseph, 1997. "Collateral Damage: Refinancing Constraints and Regional Recessions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(4), pages 496-516, November.
  21. Patric H. Hendershott & Robert Van Order, 1988. "Pricing Mortgages: An Interpretation of the Models and Results," NBER Working Papers 2290, National Bureau of Economic Research, Inc.
  22. Green, Richard K. & LaCour-Little, Michael, 1999. "Some Truths about Ostriches: Who Doesn't Prepay Their Mortgages and Why They Don't," Journal of Housing Economics, Elsevier, vol. 8(3), pages 233-248, September.
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Cited by:
  1. Guiso, Luigi & Sodini, Paolo, 2012. "Household Finance: An Emerging Field," CEPR Discussion Papers 8934, C.E.P.R. Discussion Papers.
  2. Amir E. Khandani & Andrew W. Lo & Robert C. Merton, 2009. "Systemic Risk and the Refinancing Ratchet Effect," NBER Working Papers 15362, National Bureau of Economic Research, Inc.
  3. Toshio Kimura & Naoki Makimoto, 2008. "Optimal Mortgage Refinancing with Regime Switches," Asia-Pacific Financial Markets, Springer, vol. 15(1), pages 47-65, March.
  4. Barry Bosworth & Rosanna Smart, 2009. "The Wealth of Older Americans and the Sub-Prime Debacle The Wealth of Older Americans and the Sub-Prime Debacle," Working Papers, Center for Retirement Research at Boston College wp2009-21, Center for Retirement Research, revised Nov 2009.

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