January 18, 2011 6:19PM

Prepayment Penalties Help Risky Borrowers

The thing that probably bothers me most about "consumer protection" in the financial area is the obsession with banning products, or characteristics, that sound bad, but that are actually beneficial to consumers.  An example of such is the prepayment penalty.

Basically a prepayment penalty is a fee the borrower pays if they pay off their mortgage early.  The usual reaction from "consumer advocates" is "that's horrible" -- why should someone have to pay in order to re-finance or get out of their mortgage.  Or that the prepayment penalty would make it difficult for the borrower to take advantage of lower rates or an improvement in their credit. 

A new NBER working paper lays out the case of why prepayment penalties are actually good for the riskiest (worse credit) borrowers.  The paper also explains why we are more likely to see prepayment penalties in the subprime market than in the prime.  The logic of the paper is that prepayment penalties help to ensure that  "pools of mortgages do not become disproportionately composed only with the riskiest borrowers over time."

With any given pool of subprime borrowers, some of those borrowers will see their credit quality improve over time.  Maybe they establish a good payment history.  When the pool is initially priced, which will determine the interest rate charged, that pricing is based upon the average risk of the pool.  If however, borrowers can leave the pool as their credit improves, then the average credit quality of the pool will decline.  Investors know this.  So, in the absence of prepayment penalties, the average interest charged will have to be substantially higher.  Essentially the prepayment penalties results in a cross-subsidy from subprime borrowers whose credit improves to those borrowers whose credit does not improve. 

Recognizing this logic also explains why we don't often see prepayments in prime mortgages:  prime borrowers are already close to the best credit, so there's less chance of their credit improving and less room overall for improvement.  Of course, there's nothing stopping the borrower from waiting for their credit to improve before getting a mortgage.