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

Christopher Mayer, Tomasz Piskorski and Alexei Tchistyi

No 16586, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: D12 D14 D53 G14 G21 G28 R31 R38 (search for similar items in EconPapers)
Date: 2010-12
New Economics Papers: this item is included in nep-ban, nep-cba and nep-ure
Note: AP PE
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Citations: View citations in EconPapers (6)

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.

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