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The Inefficiency of Refinancing: Why Prepayment Penalties Are Good for Risky Borrowers

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  • Christopher J. Mayer
  • Tomasz Piskorski
  • Alexei Tchistyi

Abstract

This paper explores the practice of mortgage refinancing in a dynamic competitive lending model with risky borrowers and costly default. We show that prepayment penalties improve welfare by ensuring longer-term lending contracts, which prevents the mortgage pools from becoming disproportionately composed of the riskiest borrowers over time. Mortgages with prepayment penalties allow lenders to lower mortgage rates and extend credit to the least creditworthy, with the largest benefits going to the riskiest borrowers, who have the most incentive to refinance in response to positive credit shocks. Empirical evidence from more than 21,000 non-agency securitized fixed rate mortgages is consistent with the key predictions of our model. Our results suggest that regulations banning refinancing penalties might have the unintended consequence of restricting access to credit and raising rates for the least creditworthy borrowers.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16586.

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Date of creation: Dec 2010
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Publication status: published as Mayer, Christopher, Tomasz Pisk orski, and Alexei Tchistyi. 2013 . “The Inefficiency of Refinancing: Why Prepayment Penalties Are Good f or Risky Borro wers.” Journal of Financial Economics , Vol. 107(2), 694 - 714.
Handle: RePEc:nbr:nberwo:16586
Note: AP PE
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Find related papers by JEL classification:

  • D12 - Microeconomics - - Household Behavior - - - Consumer Economics: Empirical Analysis
  • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
  • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
  • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
  • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
  • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
  • R31 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - Housing Supply and Markets
  • R38 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - Government Policy

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Cited by:

  1. Steinbuks, Jevgenijs, 2015. "Effects of prepayment regulations on termination of subprime mortgages," Journal of Banking & Finance, Elsevier, vol. 59(C), pages 445-456.
  2. Benjamin J. Keys & Tomasz Piskorski & Amit Seru & Vikrant Vig, 2012. "Mortgage Financing in the Housing Boom and Bust," NBER Chapters, in: Housing and the Financial Crisis, pages 143-204 National Bureau of Economic Research, Inc.
  3. Shane M. Sherlund, 2008. "The past, present, and future of subprime mortgages," Finance and Economics Discussion Series 2008-63, Board of Governors of the Federal Reserve System (U.S.).
  4. Morgan J. Rose, 2011. "Prepayment Penalties: Efficieny and Predation," UMBC Economics Department Working Papers 11-133, UMBC Department of Economics.
  5. 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.).

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