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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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    More about this item

    Keywords

    Inefficiency of refinancing; Prepayment penalties; Risky borrowers; Mortgages;
    All these keywords.

    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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