Mortgage termination due to prepayments in India

Abstract

Mortgage termination due to prepayment is an important issue in the pricing of mortgage and mortgage-backed securities (MBS) due to its stochastic nature. In developing countries where MBS is not yet fully developed, mortgage termination affects the flow of funds to the lenders. Recent literature has used option price models (OPM) to analyse prepayments. Prepayment is a ‘call option’ whose price is dependent on fluctuation in market interest rates. However, the termination of mortgage in housing is not as ‘ruthless’ as OPM theory would suggest, primarily because households are not financiers in a ‘strict sense’. Recent literature has used the Cox proportional hazard model to model mortgage termination. The idea is that other household-related variables besides option price of the instrument jointly determine the mortgage termination. The Cox proportional hazard model is used to analyse prepayment of mortgage behaviour in India. The results indicate that financial concerns (like option price, loan to value ratio and monthly principal and interest to income ratio) are important determinants besides household characteristics. Self- employed or low educated or single borrowers have less probability of prepaying the loan. An important variable inducing prepayment is irregular repayment behaviour of borrower. If loan repayment is in arrears for some months, borrowers often terminate their liability by prepaying.