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