Ruud Koning (Groningen):
Modelling prepayment risk
One of the most important financial decisions a household makes is the purchase of a home. In most European societies, households finance this purchase through a mortgage. The household promises to make regular interest payments, and repayment of the principal when the mortgage matures. Often, life insurance policies are attached to such mortgages so that the mortgage is repaid in case the mortgagor dies before the end of the contract. An important characteristic of such mortgage loans is the implicit option available to mortgagors: they can prepay their loan under certain conditions. This risk of prepayment makes the duration of a portfolio of mortgages stochastic which has implications for the re-finance policy by the mortgagee. We give an overview of recent literature on prepayment, and on empirical approaches to modelling
the prepayment risk. Different models are explained using a data set of about ten thousand mortgage loan contracts covering the years 1998 to 2003 from the Netherlands. We find that prepayment behavior depends on the type of mortgage product, size of the loan, and the age of the mortgagor at the time the contract is signed.
In association with the Tinbergen Institute.
- Franc Klaassen (AE)
- Maurice Bun (KE)
- Aljaz Ule (AE/CREED)
- Florian Wagener (KE/CeNDEF)