Mortgage Pricing Implications of Prepayment: Separating Pecuniary and Non-pecuniary Prepayment

Abstract

In the study of mortgage loan pricing, prepayment and default hazards are considered. While default results in loss of initial capital, prepayment is the more frequent termination event. This study makes a distinction between pecuniary and non-pecuniary prepayments in the mortgage pricing model. Pecuniary/non-pecuniary prepayments are distinguished from each other based on whether the market interest rate at prepayment is below/above the rate at origination, and thus whether mortgage lenders/investors can reinvest the proceeds at a lower/higher interest rate using the proceeds from a prepaid loan. Using a sample of 30-year fixed-rate mortgage loans for home purchase, this study finds that pecuniary and non-pecuniary prepayments are affected differently by certain overlapping factors and are driven by some unique factors. The results also show that combining these two types of prepayments into a single prepayment measure may yield inaccurate predictions of loan termination probabilities. The results from the mortgage pricing model indicate that pecuniary and non-pecuniary prepayment risks, together with default risk, contribute separately to the pricing of a loan.