Mortgage Choice: What's the Point?

Abstract

This paper shows that, in the presence of transaction costs payable by borrowers on refinancing, it is possible to construct a separating equilibrium in which borrowers with differing mobility select loans with different coupon rate/points combinations. We also show that, in the absence of such costs, no such equilibrium is possible. This provides a possible explanation for the large menus of mortgages typically encountered by potential borrowers, and suggests that the menu of contracts available at the time of origination should be an important predictor of future prepayment. We numerically implement such an equilibrium, developing the first contingent claims mortgage valuation algorithm that can quantify the effect of self-selection on real contracts in a realistic interest rate setting. Our algorithm allows investors to account for self-selection when valuing mortgages and mortgage-backed securities. It also, for the first time, allows lenders to determine the optimal points/coupon rate schedule to offer to a specified set of potential borrowers, given the current level of interest rates. ∗The authors thank Jan Brueckner, Patric Hendershott, Dwight Jaffee, Ravi Jagannathan, Steve LeRoy, Frank Nothaft, Chester Spatt, Matt Spiegel, and seminar participants at U.C. Berkeley, Hautes Etudes Commerciales (HEC), the 1995 meeting of the American Real Estate and Urban Economics Association, and the 1995 Ohio State University Summer Real Estate Workshop for helpful comments and suggestions. We are grateful for financial assistance from the Berkeley Program in Finance, from the U.C. Berkeley Committee on Research, and from the Fisher Center for Real Estate and Urban Economics.