Prepaying Mortgages

Mike Konczal says that all mortgages should be prepayable without penalty. He’s right — but in fact he doesn’t go far enough. As Tyler Cowen notes, it would be even better if mortgages could be prepaid at a discount when mortgage rates rise — or property prices fall.

The result would be a sharp rise in mortgage prepayments: you’d repay when mortgage rates rise, by repurchasing your mortgage at a discount, and you’d repay when mortgage rates fall, by refinancing. Mortgage rates in general might have to go up somewhat in order to make up for all this new prepayment risk, but to offset that there would be significantly less default risk. And right now, when mortgage rates are low, is a good time to implement something like this: the damage you cause to a bank when you prepay a low-rate mortgage is very limited.

It’s true that prepaying at a discount doesn’t work as easily in the heterogeneous US as it does in the more homogenous Denmark, but there are ways around that; at the very least, homeowners should be given the opportunity to offset their mortgage liabilities in the broader capital markets. There’s got to be some way of doing that, and I’m not talking about zero-sum games like Bob Shiller’s housing futures.

Comments

[Bruce Vande...:]

In the world of private mortgages prepaying at a discount is common. Both parties can benefit. Negotiations can be done at the kitchen table.

I don't know why banks don't offer discounts for prepaying.

Sep 28 08:52 AM

[MarkitWacha:]

buy put options on IYR for a hedge against housing price falls.

Sep 28 10:08 AM

[djackson:]

There are so many issues with this, it is hard to know where to start. 1.) Assume the discount arises from interest rates going up. If it is a conventional loan insured by one of the government agencies, essentially you are forcing the agency to eat the loss, i.e., the difference between the discounted price and par. So it represents yet another subsidy from the taxpayer to a homeowner. If it is a whole loan retained by the bank, because of the accounting rules, you are again forcing a loss that otherwise is not recognized. Again, it becomes a transfer of wealth from the bank to the homeowner. If it is a whole loan packaged and sold into the capital markets, the issue becomes even more complex. The right to pay off a mortgage at a discount would change the dynamics of value between tranches and this uncertainty would have to be priced into the deal and thus into the original mortgages.
2.) If the discount arises from the credit impairment of the homeowner, from whence comes the money to pay off even a discounted mortgage? And who determines what the discount should be?

You are not changing the option value of prepayments as they are traditionally understood and modeled, you are changing the whole dynamic driving it. Until those who would be undertaking the risk of owning these mortgages can study and comprehend this new dynamic (and this would take a long time), I think you would find a very high premium would be charged to originate such mortgages.

Sep 28 10:36 AM

[tobi:]

Some nostalgia deadmalls.com/
I think that tells the story

Sep 28 10:53 AM

[Alex_G:]

The Danish model Tyler Cowen is speaking of allows the mortgage holder to buy a security to PAIR OFF his mortgage, effectively pre-paying it. He does not actually go to the bank and pay it off.

As djackson above states, a direct payoff would not be workable on many different levels.

Alex

Sep 28 11:00 AM

[Graham and ...:]

Problem is that banks' interests are diametrically OPPOSITE of those of borrowers. As such, banks prefer STUPID borrowers that run up their own expenses, not prudent borrowers that use good judgment in borrowing (and paying).

Sep 28 11:27 AM

[a fat panda:]

Bruce,

The answer is pretty simple, banks don't own many of these mortgages. They have been sold in packages to third parties who don't have the power to negotiate. What mortgage servicer is going to broker a deal that cuts his fees?

If the banker does take the prepayment, he has to reinvest it. That is work. Also if rates rise, and the prepayment requires him to lose money, it is something that he would have to report to the shareholders. It isn't that the bankers have opposite interests as much as they have little interest in this solution. They would prefer to let the mortgage rate rise and do nothing.

On Sep 28 08:52 AM Bruce Vanderveen wrote:

> In the world of private mortgages prepaying at a discount is common.
> Both parties can benefit. Negotiations can be done at the kitchen
> table.
>
> I don't know why banks don't offer discounts for prepaying.

Sep 28 11:49 AM

[a fat panda:]

" As Tyler Cowen notes, it would be even better if mortgages could be prepaid at a discount when mortgage rates rise — or property prices fall."

What owning CDOs isn't risky enough? You want the bank to assume a direct interest in the rise and fall of real estate prices with federally insured money. That is crazy.

Sep 28 11:52 AM

[casey00001:]

How about people read the mortgage documents before they sign them. If its important to have a mortgage without a pre-payment penalty then get one structured without it. Caveat Emptor, let the buyer beware. Its that simple.

Sep 28 05:48 PM

[Kinabalu:]

Shhhh - Some in Congress are just stupid enough to go for some simplistic sop like this. Long term it makes mortgages that much more unattractive to lenders/investors. The result would be higher mortgage costs/rates.

Sep 28 08:37 PM