Abstract
Observed mortgage prepayment and default rates have been far different than the ruthless option exercise rates predicted by contingent claims models of mortgage pricing. The discrepancies have been attributed to both the competing‐risk nature of prepayment and default and to transactions costs. This paper tries a different means of reconciliation. We introduce a third stochastic process, household income, into the usual pricing model that includes only the spot interest rate and the house price. The presence of income allows considering consumption‐theoretic determinants of termination. The role of mortgage underwriting rules in restricting optimal prepayment is also explicitly modeled. Numerical ex ante prepayment and default rates based on the theoretical model come much closer to historical experience.
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