Lawyers and economists use two different languages to describe the same facts. When a lawyer speaks of a contractually or legally defined right, an economist thinks of a mathematically structured option. Such options can always be assigned a generic value by applying standard valuation formulae. Some of them, as is well known to anyone investing in the stock or bond markets, are even traded and have thus been given a market price. Early repayment presents a perfect example. It is one of many options which together form a mortgage contract that assigns rights to consumers and lenders. Options embedded in mortgage contracts differ vastly in their economic significance and characteristics, depending on the type of product. In a fixed-rate mortgage contract, borrower default risk caused by rising interest rates is limited. On the other hand, there is prepayment risk as consumers may refinance when rates have dropped beyond a certain threshold defined by transaction costs. In contrast, in an adjustable-rate contract, default risk through rising inflation may be very significant while prepayment risk is very low as there is little financial incentive to switch loans. What remains are so-called “non-financial” prepayments related to labor or housing market factors, e.g. a move caused by professional change or a house sale in favorable conditions.

Fixed-rate mortgages may produce quite different cost profiles, depending on whether they are “callable” through financially motivated prepayments or “non-callable.” Chart 1 displays the value of two different pools of fixed-rate mortgages in response to interest rate changes. Loans in both pools carry the same contract rates. The non-callable mortgage loan pool rises (falls) in value if interest rates drop (increase), behaving just as the most common government or corporate bonds. The callable mortgage loan pool behaves differently it hardly rises in value if interest rates drop, due to the fact that prepayments are made which have to be reinvested at the current market rate. The callable fixed-rate loan pool is thus of a hybrid nature: it resembles a pool of adjustable-rate loans if interest rates fall, and a pool of non-callable fixed-rate loans if interest rates rise. Aggregating over all interest rate scenarios, its value must be lower than that of a non-callable mortgage loan. In order for both to fetch the same price on the capital market, investors will require a higher coupon for the callable loan than for the non-callable loan.