Why Banning Prepayment Penalties Won't Help Borrowers

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With the growing alarm over the mounting losses in the mortgage industry, it was inevitable that the Democratic presidential candidates would offer various "solutions." As always, they have diagnosed the problem as too much contractual freedom in the marketplace, and so prescribe ever more government regulations and prohibitions as a way to (allegedly) make our economy stronger.

The Democratic proposals are wide-ranging, including a national registry of brokers, uniform standards for broker licenses, and better scrutiny of a borrower’s ability to repay. But the recommendation that seems the most commonsensical to the average citizen — and which is explicitly recommended by both Senators Dodd and Clinton — is an outright ban on prepayment penalties. After all, the thinking goes, isn’t it completely unfair to punish someone who acts responsibly and pays down his mortgage ahead of schedule? So surely it will help borrowers if the government steps in and rules out such unfair loan contracts, right?

The perhaps surprising answer is "no," it actually hurts borrowers (and lenders) when possible, voluntary contracts are declared inadmissible. Despite the presidential candidates’ desires to mother all of us, most people aren’t nearly as incompetent as the politicians would have us believe, especially when it comes to huge decisions such as financing a home purchase. The reason some borrowers are willing to sign contracts that include prepayment penalties is that the interest rate is correspondingly lower. If you think a prepayment penalty is absurd, you don’t need Hillary Clinton to rescue you. You can simply choose to take out a mortgage without a prepayment penalty (and pay a slightly higher interest rate because of your decision). Pretty simple, eh?

What most people don’t realize is that helping the borrower by giving him the option of prepaying the mortgage necessarily hurts the lender. When the bank lends you $200,000 to buy a house, it needs to compare the pros and cons of that loan with other possible investments. For example, it could have bought $200,000 worth of government bonds instead. Now from the bank’s point of view, one of the benefits of the mortgage loan is that it pays a higher rate of return than the government bond. But one of the drawbacks is that, if interest rates drop, the homeowner can refinance, whereas Uncle Sam can’t call in his bonds (at least the ones issued since 1985).

In other words, when the bank is planning its cash flows into the future, it is far more confident in fixed payments (such as offered by government bonds) as opposed to payment streams that might suddenly stop (such as a homeowner who refinances). In the financial community this is called prepayment risk. And guess what? If bankers are going to take on riskier investments, they require correspondingly higher expected returns. That’s part of the reason that mortgage rates are higher than U.S. bond rates. (Another reason of course is that a homeowner is more likely to default than the U.S. Treasury.) Including prepayment penalties in mortgage contracts mitigates this risk, and so allows the lender to charge a lower interest rate than he would accept without such a built-in compensation.

Now what happens if Senator Clinton’s proposed ban on prepayment penalties goes through? It will simply remove options from the homebuyer’s table, since (as we said above) people already have the option of mortgage contracts with no prepayment penalties. Generally speaking, restricting consumers’ choices doesn’t help them. Far from being a pure redistribution of wealth from rich bankers to struggling homebuyers, the proposed ban will simply throw sand in the gears of the banking industry and lead to higher average mortgage rates.

In case the reader is still unsure, let’s make the issue crystal clear. Why have such a half-hearted measure like Clinton’s? After all, if we really want to help homebuyers (and we don’t care about rich bankers), let’s pass a law requiring all first-time mortgage applicants to get a $25,000 signing bonus from the lender. Why, think of how much this would help towards staving off delinquency and propping up the teetering subprime market! The problem with this hypothetical suggestion, of course, is that the banks would simply increase their rates in order to compensate for the $25,000 giveaway. Banks aren’t stupid; they’re not simply going to give money away to borrowers.

The mortgage industry is certainly in a mess, and the government’s policies deserve to be scrutinized. But the Democratic calls for bans on prepayment penalties will only restrict options and thus make everyone — especially homebuyers — worse off.

Bob Murphy [send him mail] has a Ph.D. in economics from New York University, and is the author of The Politically Incorrect Guide to Capitalism. He has a personal website at ConsultingByRPM.com

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