Working Paper

The Behavioral Relationship Between Mortgage Prepayment and Default

Abstract: An implication of the dual trigger theory of default is that mortgage borrowers who experience an unexpected financial reverse will prepay their mortgage rather than default if their equity in the house is positive. We test this idea with a new data set created by matching mortgage servicing records and credit bureau records to classify prepayments by what happens subsequently. In particular, we can identify a subset of prepayments that seems consistent with the dual trigger theory. If the theory is correct, these prepayments should exhibit similarities to defaults in the data set rather than other prepayments. We test this idea and find that these prepayments are in fact more closely related to defaults than to other prepayments. However, our data also support a role for strategic default. Understanding these relationships may be critical in predicting mortgage default when house prices decline after a long period of increases. While our work is only a first step in this direction, we believe that a better understanding how prepayments may be driven by financial reverses would be valuable for participants in and regulators of mortgage markets.

Keywords: mortgage finance; prepayment; default; nested logit model;

JEL Classification: D12; G51; R21;

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Bibliographic Information

Provider: Federal Reserve Bank of Philadelphia

Part of Series: Working Papers

Publication Date: 2021-03-22

Number: 21-12