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The inefficiency of refinancing: Why prepayment penalties are good for risky borrowers

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  • Mayer, Chris
  • Piskorski, Tomasz
  • Tchistyi, Alexei

Abstract

This paper provides a theoretical analysis of the efficiency of prepayment penalties in a dynamic competitive lending model with risky borrowers and costly default. When considering improvements in the borrower's creditworthiness as one of the reasons for refinancing mortgages, we show that refinancing penalties can be welfare improving and that they can be particularly beneficial to riskier borrowers in the form of lower mortgage rates, reduced defaults, and increased availability of credit. Thus, a high concentration of prepayment penalties among the riskiest borrowers can be an outcome of efficient equilibrium in a mortgage market. We also provide empirical evidence that is consistent with the key predictions of our model.

Suggested Citation

  • Mayer, Chris & Piskorski, Tomasz & Tchistyi, Alexei, 2013. "The inefficiency of refinancing: Why prepayment penalties are good for risky borrowers," Journal of Financial Economics, Elsevier, vol. 107(3), pages 694-714.
  • Handle: RePEc:eee:jfinec:v:107:y:2013:i:3:p:694-714
    DOI: 10.1016/j.jfineco.2012.10.003
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    Cited by:

    1. repec:eee:jbfina:v:82:y:2017:i:c:p:165-179 is not listed on IDEAS
    2. Djordjevic, Ljubica, 2015. "Essays in household finance," Other publications TiSEM ad3edc86-915e-4ce8-ba38-b, Tilburg University, School of Economics and Management.
    3. Jan K. Brueckner & Kangoh Lee, 2014. "Optimal Risk-Sharing in Mortgage Contracts: The Effects of Potential Prepayment and Default," CESifo Working Paper Series 4979, CESifo Group Munich.
    4. Beltratti, Andrea & Benetton, Matteo & Gavazza, Alessandro, 2017. "The role of prepayment penalties in mortgage loans," Journal of Banking & Finance, Elsevier, vol. 82(C), pages 165-179.
    5. Steinbuks, Jevgenijs, 2015. "Effects of prepayment regulations on termination of subprime mortgages," Journal of Banking & Finance, Elsevier, vol. 59(C), pages 445-456.
    6. Marianna Brunetti & Rocco Ciciretti & Ljubica Djordjevic, 2016. "Till Mortgage Do Us Part: Refinancing Costs and Household’s Bank Switching," CEIS Research Paper 364, Tor Vergata University, CEIS, revised 13 Dec 2017.
    7. Amromin, Eugene & Kearns, Caitlin, 2014. "Access to Refinancing and Mortgage Interest Rates: HARPing on the Importance of Competition," Working Paper Series WP-2014-25, Federal Reserve Bank of Chicago.
    8. repec:icb:wpaper:v:4:y:2017:i:1:212-219 is not listed on IDEAS

    More about this item

    Keywords

    Inefficiency of refinancing; Prepayment penalties; Risky borrowers; Mortgages;

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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