A study of mortgage prepayment risk [pdf].
Report launched at Staple Inn on 12 November 2001.

Executive Summary

As recently as five years ago the average tenure of a residential mortgage in the UK was around seven years. Most lenders will tell you that the equivalent figure today is nearer four, due mainly to consumers? increased willingness to switch lender for a better deal. This is a worrying trend for lenders since, because of the high costs of acquiring a mortgage, mortgages typically need to remain on the books for several years in order to be profitable.

Fixed rate loans, which account for around one third of UK residential mortgages, typically have even shorter lives. They pose a particular problem for lenders, because of the financial impact of early repayment on their funding arrangements. Because of the significance of this problem, eight of the top ten lenders, representing over 65% of the nation's outstanding loans, participated in this six-month long study, providing the necessary data for analysis.

The work undertaken explores both the causes and the results of prepayment of fixed rate mortgages. The techniques employed shed new light on the reasons why customers repay ahead of schedule. They advance the industry's understanding of the circumstances in which prepayment is most and least likely.

Four drivers are shown to have a significant impact on prepayment behaviour:

• Age of the fixed rate loan? From the point at which a borrower takes out a fixed rate mortgage, it usually takes some time for a significant interest differential to appear. And after having gone through the process of applying for one mortgage, few borrowers immediately look to re-mortgage again. Prepayment rates generally rise in the second half of the fixed rate period, but tail off before the end of the period.
• House price inflation? When house price inflation is high, the number of home moves increases. Increased activity in the housing market results in increased prepayment.
• Interest differential? This measures the tangible saving that a borrower could make by switching to another fixed rate or variable rate mortgage. A high interest differential encourages borrowers to prepay, but the effect of interest movements is far from linear.
• Prepayment charges? These charges create a cost to prepayment that acts as a disincentive to prepay. We observed that charges over a certain level appeared to discourage prepayment significantly.

These four factors interact with each other and with a number of other variables to determine the likelihood of early prepayment.

As well as exploring the causes of prepayment, this study considers the impact of prepayment on profitability and value creation and shows how techniques such as projection modelling, predictive modelling and stochastic modelling can be used to manage prepayment risks better. In doing so, it points towards ways of reducing prepayment risk through product design, pricing and customer retention initiatives.