The Inefficiency of Refinancing: Why Prepayment Penalties Are Good for Risky Borrowers
AbstractThis paper explores the practice of mortgage refinancing in a dynamic competitive lending model with risky borrowers and costly default. We show that the prepayment penalties are welfare improving, and that they are more beneficial to borrowers with higher risk of default. The empirical evidence supports the assumptions and predictions of the model, including higher sensitivity of refinancing decisions of more risky borrowers with respect to the ex-post changes in their creditworthiness and that, conditional on the borrower's type, the mortgages with prepayment penalties have lower premia, the more so the more risky is the borrower. These results suggest that the legislation banning refinancing penalties might have unintended consequences. Instead of protecting would-be homeowners from predatory lending, the new law might end up protecting them from credit.
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Bibliographic InfoPaper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 998.
Date of creation: 2008
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Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
Web page: http://www.EconomicDynamics.org/society.htm
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- Christopher J. Mayer & Karen M. Pence & Shane M. Sherlund, 2008. "The rise in mortgage defaults," Finance and Economics Discussion Series 2008-59, Board of Governors of the Federal Reserve System (U.S.).
- Bucks, Brian & Pence, Karen, 2008. "Do borrowers know their mortgage terms?," Journal of Urban Economics, Elsevier, vol. 64(2), pages 218-233, September.
- Michael Spence & Patricia Clarke Annez & Robert M. Buckley, 2009. "Urbanization and Growth : Commission on Growth and Development," World Bank Publications, The World Bank, number 2582, October.
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