Mortgage Valuation with Optimal Intertemporal Refinancing Strategies

Abstract

This article extends previous work on mortgage valuation in two ways. First, I identify the prepayment boundary by solving for the borrower's optimal prepayment strategy over the expected tenure in the house. Previous work has treated the prepayment decision as a one-time decision, not as an element of a multiperiod strategy. Second, the model incorporates borrower heterogeneity in terms of expected tenure in the house. The results show that the optimal refinancing strategy differs significantly from a sequence of one-time decisions. A borrower following the optimal strategy is less aggressive in refinancing and pays more interest and less transaction costs than does a borrower following a myopic strategy. Estimated mortgage values are higher and interest rate sensitivity is lower when compared to values calculated using the traditional approach.