Mortgage Prepayment Penalties: A Market Solution to Adverse Selection or a Shrouded Attribute?
Michael Varley, Joint Program in Financial Economics PhD student
Mortgage prepayment penalties protect lenders from the risk of a premature full payment of a loan where they would lose out on the stream of interest payments initially expected throughout the entire amortization schedule. While a benefit to lenders, are any benefits passed through to borrowers? If lenders are worried their loan portfolio will deteriorate in credit quality as their best customers prepay their loans, then we should expect prepayment penalties to improve credit outcomes either by increasing credit supply or lowering the price of credit. However, if prepayment penalties are shrouded in the loan contract, borrowers may not benefit. This proposal seeks to answer this question by looking at three states that have banned prepayment penalties on certain mortgages with loan balances at or below state-mandated thresholds. These thresholds varied across states and time, providing valuable quasi-experimental variation in the provision of prepayment penalties on a loan contract.