Mortgage Prepayment: Economically Suboptimal

Greg Mankiw reckons that prepayment

penalties are a Bad Thing, and approves of David

Laibson’s plan to abolish them. Writes Mankiw:

When I refinanced my mortgage not long ago, one of my first questions was,

Are there any prepayment penalties? I figured that as long as the answer was

no, I was less likely to be hit with strange, hidden provisions down the road.

Mankiw’s commenters (and Brad

DeLong’s, too) get into a healthy debate about this proposal, but now Tomasz

Piskorski and Alexei Tchistyi have a

long paper out which claims with great empirical rigor that in a perfect

world the exact opposite would be true. Instead of no mortgages having prepayment

penalties, all mortgages would ban prepayment altogether, or at least have very

large prepayment penalties.

Peter Coy tries

to explain, in English:

The economists say the optimal loan contract would outright ban getting a

new loan from a different lender. There are no such bans. But they say that

the prepayment penalties that are common in subprime loans are a good second

best. How could that be? Because lenders will offer more favorable terms if

they know that they’ll be able to hang onto the loan long enough for it to

be profitable. If they fear that the borrower will refinance at the drop of

a hat, they’ll give less favorable terms.

In fact it’s slightly more complicated than that. Here’s what the paper says:

The optimal contracts do not allow borrowers to refinance their mortgages

with another lender. Offering this option would increase the borrower’s reservation

value, which would limit the ability to provide him incentives to repay his

debt, resulting in a decrease of efficiency of the contract.

I’m not going to try to get into the specifics of reservation value (see page

11 of the paper for all the details), but it’s basically homeowner’s equity:

the amount of money that the borrower would have left over if he sold the house

and moved.

Indeed, the paper says that not only prepayment but even renegotiation is a

bad idea in an economically-optimal mortgage:

We also did not allow for contract renegotiations, because a possibility

of renegotiation would lead to a suboptimal contract.

I have to say that I’m having a lot of difficulty with this idea: since a successful

renegotiation has to be acceptable to both sides, what’s not to like about it?

If the lender would be better off with the original contract, it can simply

refuse to renegotiate.

In any case, I’m sure that Greg Mankiw, who recently refinanced his mortgage,

is happy that he was able to do so. But it is interesting that in some kind

of ideal world, there would be enormous-to-the-point-of-insurmountable obstacles

preventing him from doing just that.

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