The effect of prepayment penalties on the pricing of subprime mortgages

This paper investigates the effect of prepayment penalties on the pricing of subprime residential mortgages. The paper is the first to consider that mortgage price and prepayment penalty may be chosen jointly, making single-equation estimates of the effect of prepayment penalty on price biased. Using a model that accounts for endogeneity of price, loan to value, and prepayment penalty, we find that prepayment penalties are associated with lower loan prices. This finding is important because perceptions that prepayment penalties harm borrowers have led many states to restrict their use, regulation that may reverse the gains in credit availability achieved over the last decade. (C) 2007 Elsevier Inc. All rights reserved.