Valuing the Mortgage Borrower's Prepayment Option

Abstract

This paper investigates the value of the prepayment option that normally accompanies a fixed-rate mortgage. Using the two-state option-pricing model developed by Bartter and Rendleman, the paper presents simulations of prepayment option values using several sets of interest rate parameters. The sensitivity of the value of the option to changes in various aspects of the mortgage contract is assessed. Prepayments are not priced separately in the market from the underlying mortgage, so the paper investigates how the inclusion of a prepayment option affects the contract interest rate. Finally, there is reason to believe that any option-pricing model will overestimate the value of a mortgage prepayment option. The size of this bias is assessed indirectly and is found to be rather small. Copyright American Real Estate and Urban Economics Association.

Can an Islamic model of housing finance cooperative elevate the economic status of the underprivileged?

“…The real estate finance literature illustrates various ways of pricing this option either as a higher interest rate or a higher mortgage initiation fee (see Hall, 1985).…”

“…It should be noted that our analysis does not incorporate the relatively low administrative, default and transaction costs embedded in the two contrasting mortgages (see Buijs, 1998;and Smets, 2000). 39 Furthermore, there is no prepayment cost in a cooperative mortgage as opposed to a formal mortgage, where it results in a higher interest rate or a higher initiation fee (see Hall, 1985). If we were to incorporate these lower costs, a cooperative would still dominate in terms of its efficiency.…”

Can an Islamic Model of Housing Finance Cooperative Elevate the Economic Status of the Underprivileged?

“…It should be noted that our analysis does not incorporate the relatively low administrative, default and transaction costs embedded in the cooperative one in contrast to the subprime one (see Buijs, 1998;and Smets, 2000). 44 Furthermore, there is no prepayment cost in a cooperative mortgage as opposed to a formal mortgage, where it results in a higher interest rate or a higher initiation fee (see Hall, 1985). If we were to incorporate these lower costs, a cooperative would still dominate in terms of its efficiency.…”

Borrower Mobility, Adverse Selection, and Mortgage Points

“…Analysis of financially-motivated prepayment also underlies option-ba^ed models of mortgage pricing, which are developed by Hall (1985), Kau, Keenan, Muller and Epperson (1992) Figure 3 shows that in equilibrium, the low-mobility borrower selects his full-information contract (the corner solution on the 45 degree line), while the high-mobility borrower selects the contract located at the intersection of his zero-profit locus and the low-mobility borrower's indifference curve. The resulting equilibrium has the low-mobility borrower choosing a zero-points mortgage, and the high-mobility borrower choosing a positive-points contract.…”