The role of interest rate environment in mortgage pricing

Contributing to the literature on the relationship between interest rates and real economy, this paper examines the effect of interest rate environment on mortgage rates with and without prepayment and default risk. We model a mortgage in an intensity-based framework and show that how high interest rate environment leads to a larger mortgage rate spread, especially, in the presence of higher prepayment or default probabilities. Our results also show that in low interest rate environment, negative spreads can be observed. Another contribution of the paper is the divergence from conventional structural models which helps in overcoming the irrationality of decision-making and its adaptability to different economic environments. We also provide case studies on the effects (and interdependence) of the prepayment and default risks on the mortgage rates.