Prepaying mortgages

By Felix Salmon
September 27, 2009
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.

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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.


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Prepayment is an option, if you don’t pay it on exercise via the ill-named “penalties”, it will be embedded in the spread. One thing for sure, prepayment won’t be free E.V.E.R. in normal times it is a bigger risk for investors than default as that has to be paid for.

Why do you need an asymmetric provision like this, which sounds like something from a populist politician. If you want a right to prepay at any time without penalty, why not encourage a plain vanilla floating rate mortgage with such a provision? Your version just forces opaque pricing, which I thought you wanted to avoid.

Where I would agree is that penalties for prepayment on a fixed rate mortgage should be on a transparent formula which should be symmetric with the discount for prepayment when market rates increase. And it might be reasonable to provide that the penalty should not allow any profit for the future years of the mortgage.

Posted by RogerS | Report as abusive

Mortgages and mortgage backed securities would have a hard time trading higher than par (100) as efficient refinance removes all upside. Investors now have an option of inefficent refinance enhancing their return.

The amount mortgage rates sould have to rise to compensate investors is a good question. There is no free lunch.

Also the few remaining prepayment modelers at street firms might find themselves in the predicament of buggy whip makers.

unfortunately, konczal’s argument with respect to banning mortgage prepayment fees is completely off the wall wrong.

he makes an odd leap: having a fee for prepayment implies that the bank is taking house price risk.

this was true in exactly one context: subprime mortgages that were meant to be refinanced. it was in fact a provision meant to screw the subprime mortgage holder.

but prepayment fees outside of that context — what’s wrong with them? as a mortgage holder, it might be possible for me to get a better rate by giving up that option.

Posted by q | Report as abusive

How about don’t buy anything if you can’t afford it? Novel idea in the U.S.,but it works every time. If you don’t have the actual cash on hand, don’t buy a house, and you don’t have to worry about anything. The inflated ego of the country in “home ownership” is actually quite amusing. You can go through life just fine without owning a home; and by the way you can accumulate more cash for retirement as well.

Posted by Frank | Report as abusive

konzcal goes on to say things like charging for prepayment will increase the amount of fees people pay on balance? huh? is he saying that people will pay refinance more if they are charged to do so?

Posted by q | Report as abusive

In commercial mortgages, prepayment takes the form of “yield maintenance,” which is a more direct statement of the real intent: that the loan is a stream of income. The problem is that model is now old-fashioned – with loans bundled, cut up, sold off (sometimes without being bundled) – but the requirements remain. Why? Because they go into the pricing, which means profit.

This is an example of how the financial institutions talk about efficiency but use their market power to maintain inefficiencies for the consumers which allow the financial institutions to make more money.

Posted by jonathan | Report as abusive

Is anyone now in a position to repay there mortgage

I am in no position to repay my mortgage, but if l was l would not want to be penalized for it