Prepayment Penalties in Residential Mortgage Contracts: A Cost-Benefit Analysis

Prepayment penalties are ubiquitous in the commercial mortgage market yet reviled and highly restricted by law and regulation in the residential mortgage market. Considering the perspectives of both the borrower and the lender, we attempt a balanced cost-benefit analysis of this controversial contract feature for residential mortgage loans. We will address the following questions: What is the economic value of the prepayment penalty feature? Why is It more prevalent in the subprime than the prime market segment? Do borrowers obtain an offsetting economic benefit when they contract for a loan containing a prepayment penalty? What is the average cost of a prepayment penalty to borrowers, and how often is this cost actually incurred? In general, although we find a significant reduction in interest rates for loans containing a prepayment penalty, the expected costs outweigh the benefits by a considerable margin.