Rational Attention Allocation in the Mortgage Market

Abstract

We propose a structural mortgage prepayment model, where mortgage holders have to allocate costly attention to implement prepayment decisions, and apply the model to US prime mortgages. Our empirical results suggest that commonly observed refinancing mistakes, such as choosing a financially suboptimal refinancing rate by waiting for too long, can be optimal responses of borrowers who allocate their attention rationally. We find that financial sophistication and experience in refinancing reduce costs for attention, while additional financial obligations cause the opposite. Compared to a situation without costs for attention, we estimate that the rational allocation of costly attention increases the value of liabilities by $4,214 for a median mortgage. We find that after the Great Financial Crisis, both the costs for attention as well as the impact of financial sophistication, experience in refinancing and additional financial obligations on the costs for attention increase. The increase of the costs for attention leads to an additional increase of the value of liabilities of 15% after the Great Financial Crisis. Our results have implications for the effectiveness of monetary policy transmission, especially, following an economic crisis.