As a result of the subprime mortgage mess, prepayment penalties are under close scrutiny. While these, like other kinds of contract terms, can be abused, there are good reasons for why they exist. In principle, they serve to extend credit to a greater number of borrowers.Mortgage loans ; Prepayment of debts

O. Emre Ergungor

English

Research Papers in Economics

Prepayment Penalties on Subprime Mortgages
by O. Emre Ergungor
September 1, 2007
ISSN 0428-1276
venience for the many people involved 
on the lending side of the deal. Most 
mortgages are sold into a mortgage 
pool and eventually to investors as 
soon as they are originated. The origi-
nator often keeps the right to service 
(collect the payments on) the mortgage 
on behalf of the investors. The lender’s 
income is the fee it collects for ser-
vicing the mortgage. Large ﬁ  nancial 
institutions, such as pension funds and 
insurance companies, like to invest 
in mortgage-related assets because 
mortgages tend to have a long life that 
matches the life of the institutions’ 
long-term liabilities, which is part of 
their risk-management strategy.
Paying a loan off early throws a stick 
in the wheels of this arrangement. 
The originator loses its servicing fee, 
and the investors receive their money 
back early, which they then have to 
invest again—after paying additional 
transaction costs and at a yield that is 
uncertain at the time they purchased 
the original mortgage. The technical 
term lenders use to capture this costly 
inconvenience is prepayment risk. In 
the end, it is the borrower who com-
pensates the lenders and investors for 
the prepayment risk in the form of 
higher interest rates.
As a result of the subprime mort-
gage mess, prepayment penalties 
are under close scrutiny.  While 
these, like other kinds of contract 
terms, can be abused, there are 
good reasons for why they exist.  
In principle, they serve to extend 
credit to a greater number of 
borrowers.
Federal Reserve Bank of Cleveland
Subprime mortgages are real estate 
loans made to individuals with less 
than perfect credit. On a credit-score 
scale of 300 to 850, those loan appli-
cants with a score less than 620 are 
usually considered subprime. (People 
with higher scores may also be put 
into this category if, for example, they 
are carrying too much debt.) The sub-
prime mortgage market emerged in the 
1980s and has grown rapidly in the last 
10 years. Over this period, more than 
5.7 million subprime loans were origi-
nated for home purchases, according 
to the Center for Responsible Lending, 
making up 38 percent of total purchase 
originations, and 1.5 million families 
became ﬁ  rst-time homeowners.
Given that subprime borrowers are 
more likely to default on their loans 
than borrowers in the prime mort-
gage market, it is no surprise that 
subprime loans come with terms that 
reﬂ  ect their higher risk. For instance, 
compared with prime loans, subprime 
loans typically have higher interest 
rates and fees. Moreover, subprime 
loans often include prepayment penal-
ties that extend farther into the future 
than those on prime loans. As sub-
prime delinquencies and foreclosures 
started to grow recently, the debate 
on lending practices in the subprime 
market has increasingly focused on 
whether the differences in the terms 
on prime and subprime mortgage 
loans are justiﬁ  ed by the differences 
in default risk and whether the loan 
terms themselves contribute to sub-
prime loans’ higher default rate com-
pared to prime mortgages. 
Prepayment penalties—paid by bor-
rowers who reﬁ  nance their mortgages 
within a few years after origination—
are under close scrutiny. Prepayment 
penalties were a contract feature of 
a signiﬁ  cant percentage of the loan 
defaults in the subprime mortgage 
market. This Economic Commentary 
explains the economic reasons why 
these contract terms exist and why they 
may be associated with higher delin-
quency rates. In this simple “thought 
exercise” I examine one channel by 
which prepayment penalties can help 
remove some of the barriers to credit 
in the higher-risk segment of the mort-
gage market. To keep the exercise 
simple, I assume that borrowers are 
rational and able to easily distinguish 
among mortgage terms, which, as we 
know, is not always the case. Prepay-
ment penalties can be used in a mul-
titude of ways in the marketplace and 
some of those uses are potentially 
abusive. My objective is not to justify 
every possible use but to shed light on 
some potential economic beneﬁ  ts.
   Prepayments as a Tool 
for Managing Liquidity
How can people on a limited budget 
lower their monthly mortgage pay-
ments? A larger downpayment would 
be an obvious choice, but if they have 
saved little or if their savings are ear-
marked for some other purpose—the 
kids’ education, a new business ven-
ture—that option is out of the picture. 
A prepayment penalty offers an alter-
native.
A typical mortgage amortizes over 30 
years, but it is difﬁ  cult to ﬁ  nd a hom-
eowner these days who will stay with 
the same mortgage until it is fully paid 
off. People reﬁ  nance to get a better 
deal or pay off a loan when they move 
to a different location. While the abil-
ity to prepay is a great convenience for 
the borrower, it is also a great incon-But what if the borrower could credi-
bly commit to not prepaying the loan? 
By giving up the right to prepay, the 
borrower would reduce the lender’s 
and investors’ prepayment risk and 
would be rewarded through changes 
in other loan terms, such as a lower 
interest rate.
A prepayment penalty accomplishes 
just that. It makes it expensive, albeit 
not impossible, for the borrower to 
reﬁ  nance his loan, and even if he does 
reﬁ  nance, he pays a penalty that would 
presumably compensate the lend-
ers and investors for their trouble. In 
return for the prepayment penalty, the 
interest rate is set at a lower level than 
it would be without the penalty. So 
prepayment penalties can be a valuable 
tool for borrowers who wish to pay 
lower monthly payments. 
Yet liquidity management is not nec-
essarily the whole story. While losing 
the ability to tweak cash ﬂ  ows to one’s 
particular needs may inconvenience 
many borrowers and push some bor-
rowers at the margin out of the market, 
economic theory suggests that prepay-
ment penalties may be playing a more 
fundamental role in the functioning of 
subprime mortgage markets.
   Information and Prices
In elementary economics we learn that 
the price of a good—be that an apple 
or a loan— will adjust until the quan-
tity of the good supplied equals the 
quantity demanded for it. Economists 
say that at this point the market will 
clear. Price is the mechanism through 
which resources are allocated efﬁ  -
ciently. In the case of loans, the price 
is an interest rate, and the market will 
clear when there is an interest rate at 
which any borrower willing to pay 
that price will get credit. But in the 
real world, the conditions necessary 
for markets to allocate goods are not 
always present. Lenders’ uncertainty 
about the creditworthiness of loan 
applicants may lead to credit ration-
ing. Borrowers cannot ﬁ  nd a loan even 
if they are willing to pay a high price; 
the interest rate alone cannot clear the 
credit market.
To see how the problem arises, imag-
ine that the lender receives two loan 
applications, one from a high-default-
risk borrower and the other from a 
lower-risk one. Both borrowers had 
similar credit problems in the past, 
so their credit scores are low and the 
same. The difference is that the credit 
troubles of the lower-risk borrower 
were caused by a one-time event, 
such as divorce, which are unlikely 
to repeat—in time, this borrower can 
repair the damage. The high-risk appli-
cant may be more prone to bad luck or 
may be suffering more from irrespon-
sibility and overall carelessness than 
any speciﬁ  c event. So he is less likely 
to repair the damage on his credit ﬁ  le; 
in fact, he may lose his job and fall 
behind in his payments again. To make 
our discussion simpler, let’s assume 
that high-risk borrowers will always 
be high-risk and low-risk borrowers 
will always remain low-risk. In other 
words, credit risk is static.
If the lender had perfect information 
about each lender’s circumstances, the 
high-risk applicant would get a high 
interest rate and the lower-risk one 
would get a lower rate, concomitant 
with his risk. But without such infor-
mation, what is a lender to do? If the 
lender announces that it will charge 
the high rate to everybody, the lower-
risk applicant may not even apply. If 
it charges the low rate to everyone, 
the lender will lose money on loans 
made to high-risk borrowers. At any 
rate in between, the loan may still be 
too expensive for low-risk borrow-
ers. In other words, it is conceivable 
that the lower-risk applicants will not 
ﬁ  nd an affordable loan in this market 
because they cannot distinguish them-
selves from the high-risk applicants; 
this problem is called adverse selection 
in economics.
In an earlier Economic Commentary, 
Joseph Haubrich and I discussed how 
a lender can offer a variety of loan 
contracts, each with terms attractive 
to only one type of borrower; lower-
risk borrowers prefer one mortgage, 
the high-risk ones prefer another. To 
see how such a mechanism might be 
designed, suppose every mortgage 
contract has identical terms except for 
the price. Instead of specifying a single 
price (the interest rate), the mortgage 
contract stipulates a two-part price; 
that is, two separate prices that will 
be paid under two different circum-
stances: an interest rate that will be 
paid as long as there is an outstanding 
balance and a prepayment penalty that 
will be paid if the mortgage is prepaid. 
A high-risk borrower recognizes that 
his fortunes are not likely to improve 
in the long run and with some luck, he 
will pay his mortgage to maturity. So, 
in return for a lower interest rate that 
will stay with him over the next 30 
years, he should be willing to accept 
a high prepayment penalty, which he 
is unlikely to pay. The lower-risk bor-
rower, on the other hand, realizes that 
while his past misfortunes prevent him 
from getting a prime loan at this time, 
he can make timely payments for a 
few years and then qualify for a new 
mortgage with a lower interest rate. 
Since the ﬁ  rst mortgage is most prob-
ably temporary, the lower-risk bor-
rower should be willing to accept a 
high interest rate as long as he keeps 
the option to prepay the mortgage at a 
low `cost—that is, a low prepayment 
penalty.
The key point in getting this two-part 
pricing to work (and why a single price 
won’t) is making sure that each loan 
applicant likes his mortgage deal better 
than the other’s. Even though the high-
risk applicant can reduce his prepay-
ment penalty by switching to the other 
mortgage deal (lower penalty, higher 
interest rate), he will end up paying 
the higher interest rate. As he is more 
likely to keep this mortgage for a long 
time, the money he might save from 
a lower prepayment penalty (should a 
prepayment occur) is small compared 
with the higher interest payment. So he 
sticks with his original contract. Like-
wise, the lower-risk applicant wouldn’t 
want the high prepayment penalty in 
return for a lower interest rate.
Thinking about this mechanism in this 
highly stylized form offers a new way 
of looking at the relationship between 
prepayment penalties and mortgage 
defaults. Roberto Quercia and his col-
leagues ﬁ  nd that loans with prepay-
ment penalties are associated with a 
lower chance of prepayment in the 
future and that the probability of pre-
payment is inversely related to the 
dollar amount of the penalty and the 
length of time the penalty is in place. 
These authors also ﬁ  nd that a mortgage 
with a prepayment penalty that lasts 
more than three years is 20 percent 
more likely to end up in foreclosure 
than a mortgage without a prepayment 
penalty. Penalties that last less than three years increase the foreclosure 
probability by 16 percent compared 
to no-penalty mortgages. Should we 
then conclude that prepayment penal-
ties actually prevent reﬁ  nancings and 
cause foreclosures? Not necessarily. 
Recall that individuals who consider 
themselves to be higher-risk are will-
ing to accept a prepayment penalty in 
return for lower interest rates. If that is 
the case, it is not surprising that these 
individuals actually don’t prepay and 
get foreclosed upon more frequently. 
What appears to be a loan term that 
some would classify as predatory may 
simply be a mechanism for allowing 
higher-risk borrowers to get credit.
According to the Center for Respon-
sible Lending, up to 80 percent of sub-
prime loans have prepayment penal-
ties, but only about 2 percent of prime 
loans carry a prepayment penalty of 
any length. This is the kind of picture 
one would expect to see if credit scores 
are effective in identifying prime bor-
rowers but are less effective in sepa-
rating good risks from bad in the sub-
prime market. This could be the case if 
credit scores are an accurate measure 
of prime borrowers’ ability to repay 
(because such borrowers have more 
transparent risk characteristics than 
subprime borrowers), or even if credit 
scores are an imperfect measure of 
everybody’s risks; because borrowers 
in the prime market are less risky, the 
imperfection of credit scores would 
cause fewer problems than in the sub-
prime market. In either case, prepay-
ment penalties may enable mortgage 
markets to function properly for indi-
viduals who cannot qualify for prime 
credit based on their credit scores. 
   Felix Qui Potuit Rerum 
Cognoscere Causas*
Do prepayment penalties cause fore-
closures or do borrowers who are most 
likely to be foreclosed upon choose 
mortgages that have prepayment penal-
ties? What are the potential economic 
costs of severely restricting or banning 
prepayment penalties? The current 
debate centers around the presumption 
that prepayment penalties do cause 
foreclosures. But we have seen that 
prepayment penalties may play two 
beneﬁ  cial roles in the mortgage mar-
ket—as a liquidity management tool 
for borrowers and as a risk manage-
ment tool for lenders—and this is by 
no means an exhaustive list.
While I do not rule out the existence of 
potentially abusive uses of prepayment 
penalties that have been documented in 
the press, there is a multitude of issues 
that should be considered before the 
fate of prepayment penalties can be 
sealed.
At this point, more research and 
debate are needed to unearth the evi-
dence that will determine where the 
line must be drawn.
  Recommended Reading
O. Emre Ergungor, and Joseph G. 
Haubrich. 2003. “Information and 
Prices,” Federal Reserve Bank of 
Cleveland, Economic Commentary, 
(May 1).
Roberto G. Quercia, Michael Steg-
man, and Walter R. Davis. 2005. “The 
Impact of Predatory Loan Terms on 
Subprime Foreclosures: The Spe-
cial Case of Prepayment Penalties 
and Balloon Payments,” The Frank 
Hawkins Kenan Institute of Private 
Enterprise, University of North Caro-
lina at Chapel Hill, (January 25).
Joseph E. Stiglitz, and Andrew Weiss. 
1981. “Credit Rationing in Markets 
with Imperfect Information,” Ameri-
can Economic Review, vol. 71, pp. 
393–410.
For more information on how loans 
are packaged and sold to investors, 
see: 
O. Emre Ergungor,. 2003. “Securitiza-
tion,” Federal Reserve Bank of Cleve-
land, Economic Commentary (August 
15).
*Happy he, who could understand 
the causes of things (Virgil, Georgics, 
Book 2, line 490).O. Emre Ergungor is an economist at the 
Federal Reserve Bank of Cleveland.
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Prepayment penalties on subprime mortgages

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