Journal of Real Estate Finance and Economics, 23:2, 235±254, 2001
# 2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Time-Varying Mortgage Prepayment Penalties
Abt Associates, 4800 Montgomery Lane, Bethesda, MD 20814
V. CARLOS SLAWSON, JR.
Department of Finance, E.J. Ourso College of Business Administration, Louisiana State University, Baton
Rouge, LA 70803-6308
Recent empirical ®ndings reveal that prepayment decisions of commercial property owners are slower than
predicted by the pure options-pricing model (OPM). Borrower decisions appearing slow, however, may be quite
rational when prepayment penalties of a time-varying nature are incorporated into the OPM. This article uses a
competing risks OPM, adjusted for each of four different categories of prepayment penalties, to analyze borrower
prepayment behavior. We ®nd the value of delaying prepayment is often higher for mortgages with declining-rate
penalties than for mortgages with static-rate penalties, frequently requiring a substantially higher interest rate
spread to trigger a re®nance. Multifamily loan prepayment records reveal the type of prepayment pattern that the
adjusted OPM indicate should occur, reducing the gap between empirical ®ndings and theoretical predictions.
The results have implications for the speci®cation of regressions ®t to historical data, for the pricing of newly
originated commercial mortgages, and for pricing in the single-family market where prepayment penalties are
Key Words: multifamily, prepayment penalty, option-pricing, commercial MBS
The commercial mortgage market in the United States is hugeÐabout $1.2 trillion in
outstanding mortgage balances as of June 1998, according to the Federal Reserve (FRB-
SEC, 1998). This is about 25 percent of the size of the single-family market. Yet it has
received scant attention in the academic literature compared to the single-family market.
This is due, in part, to the fact that there is less centralized data collection in the
commercial world. A second problem is that the terms on commercial mortgages are
heterogeneous, especially with regard to prepayment lockouts and penalties. A wide
variety of prepayment conditions are offered, ranging from simple lockouts (the
mortgages are noncallable bonds) to yield-maintenance agreements (effectively the
same as a lockout) to penalties for early repayment. In many cases, the prepayment
penalties decline over time or expire after a set number of years. The wide variety of
available terms complicates empirical modeling of mortgage-termination behavior.
We show that the time-varying nature of prepayment penalties long imposed in the
commercial sector and now in the single-family sector increases the value of delaying