Residential Mortgage Prepayment: The Evolution and Consequences of the Borrower’s Right to Prepay in the U.S.

Lynn M. Fisher

Department of Urban Studies and Planning and

The Center for Real Estate

MIT

Building 31-310

77 Massachusetts Ave.

CambridgeMA02139

617-252-1685

617-258-6991

Abstract submitted for consideration to the AREUEA Annual Meetings held in conjunction with the Allied Social Sciences Meetings in Boston, Massachusetts on January 6-8, 2006.

Abstract

This research investigates the gradual change in norms and laws regarding residential mortgage prepayment in the U.S. Indeed, the right to freely prepay a residential mortgage is a relatively new phenomenon dating from about 1980. Previously at common law, borrowers had no right to prepay a mortgage or bond in the absence of language which provided for prepayment in the promissory note or contract. According to this precedent, lenders did not have to accept an early repayment of principal or interest if such rights were not enumerated in the original contract, and the courts could not compel them to do so. In addition, borrowers and lenders were generally free to agree to terms and penalties regarding prepayment in mortgages. More recentlythe tide has turned, and new underwriting standards and state laws restrict the ability of borrowers and lenders to write prepayment penalties into mortgages at the outset of their relationship. Today, conforming residential mortgages intended to be sold to Fannie Mae or Freddie Mac cannot contain prepayment penalties and must allow borrowers to freely prepay their mortgage. In several states prepayment penalties are no longer enforceable in any residential mortgage.

Legal scholars generally argue that the common law precedent should be reversed – in the absence of language to the contrary it should be presumed that prepayment of a mortgage is allowed (Alexander 1987; Whitman 1993). More interestingly, however, is why norms and regulations should seek to limit the ability of parties to agree to terms like prepayment penalties if they decide it is in their best interest. Prepayment penalties and lock-out agreements are still enforceable in mortgages for income-producing real estate in the U.S. In addition, Greene and Wachter (2005) recentlyobserved that of the G-7 countries, only borrowers in the Netherlands have the ability to prepay residentialmortgages without penalty, and Sugimura (2002) suggests that many Japanese mortgages are freely prepayable. However, additional examples of the right to freely prepay a residential mortgage are hard to come by.

While it is tempting to argue that the right to prepay promotes labor mobility, most mortgages contain due on sale clauses that impose a form of prepayment penalty on borrowers when the market value of the mortgage falls below its face value,and such a covenant has been enforceable across the nation since the Garn-St. Germain Depository Institutions Act of 1982 (Whitman 1993; Dunn and Spatt 1985). The rules and norms that discourageother forms of prepayment penalties are aimed at the opposite interest rate scenario in which borrowers are likely to refinance as interest rates fall. On the face if it, however, global restrictions against prepayment penalties restrict the ability of borrowers and lenders to arrive at mutually beneficial contracts. What is the economic argument, if any, that warrants this sort of intervention? The role of prepayment rules in mortgages contracting has been almost completely been ignored in the real estate literature except with respect to the pricing of prepayment risk given that the right to freely prepay exists.

Therefore, this research investigates the gradual change in norms and law regarding residential mortgage prepayment along several fronts. First, we undertake a historical analysis of actual mortgages from the beginning of the 19th century to better understand the common law precedents about prepayment which can be traced from two cases in 1829 and 1845, respectively. A historical investigation is warranted in order to understand the nature of financial contracting at that time and in order to evaluate differences as compared to the modern mortgage.

Second, we undertake a theoretical analysis that adapts themodel of Dunn and Spatt (1985) to investigate the implications of different rules about prepayment and prepayment penalties. In particular, the right to prepay may affect the nature of mortgage renegotiation and the allocation of risk in these financial contracts. In cases where borrowers want to refinance their existing mortgage, there appears to be little inefficiency in allowing lenders to charge a prepayment penalty since the penalty does not materially affect a decision to sell. On the other hand when it comes time to prepay, borrowers and lenders are locked in a bilateral monopoly situation that may put the borrower at a bargaining disadvantage. Dunn and Spatt (1985) argue for heterogeneous prepayment preferences according to consumer risk tolerance. In any event, the right to prepay mortgages without penalty confers a large cost on the secondary market system in the U.S., and a critical assessment of this body of norms and laws is warranted from a market efficiency perspective.

References

Alexander, Frank S. 1987. Mortgage Prepayment: The Trial of Common Sense. Cornell Law Review 72, 288-343.

Dunn, Kenneth B. and Chester S. Spatt. 1985. An Analysis of Mortgage Contracting: Prepayment Penalties and the Due-on-Sale Clause. The Journal of Finance 40 (1), 293-308.

Green, Richard K. and Susan M. Wachter. 2005. The American Mortgage in Historical and International Context. Working paper.

Sugimura, Toru. 2002. A Prepayment Model for the Japanese Mortgage Loan Market. Asia-Pacific Financial Markets 9, 305-335.

Whitman, Dale A. 1992. Mortgage Prepayment Clauses: An Economic and Legal Analysis. UCLA Law Review 40, 851-929.