Prepayment Penalties, Adverse Selection, and Mortgage Default

Event Date: 1 March 2023

Speaker: Professor Danny McGowan, University of Birmingham

Time: 2pm

Abstract

We study how prepayment penalties influence credit availability and borrowers’ post origination loan performance using a fuzzy regression discontinuity design that exploits exogenous variation due to idiosyncrasies of US state law. Estimates show a prepayment penalty 1) reduces the probability of delinquency by 5.1%, 2) the odds of foreclosure by 4.9%, 3) increases the likelihood of loan origination by 2.5%, and 4) lowers interest rates by 6.4%. The effect sizes are larger among riskier borrowers. The findings are consistent with theoretical models’ predictions that prepayment penalties act as a borrower commitment device which acts against adverse selection as refinancing leads to a deterioration of the quality of lenders’ mortgage pools.

Published: 2 March 2023