Quantifying the Refinance Incentive and Losses from Prepayments

Abstract

A prime factor in prepayment risk is the refinance incentive. It is typically approximated by the ratio of the coupon rate and the prevailing mortgage rate minus one. This article shows that this is a very poor approximation for a wide range of relevant cases. Loan-level data can be used to compute the refinance incentive precisely, without making any approximations. Even in the presence of prepayment penalties, losses from prepayments due to refinancing can be substantial when measured in terms of market value.