Traditionally, prepayment behavior has been ascribed to two different and mutually exclusive phenomena. One is “turnover,” which involves transactions where a property is sold or liquidated. Turnover can occur when:
• The homeowner moves or trades up to a larger house.
• The obligor relocates as part of changes in their job or employment.
• The property is sold subsequent to the death of the homeowner, or as part of a divorce settlement.
• The property is destroyed by a fire or other natural disaster.
The resulting proceeds (from either the property’s sale or an insurance settlement) are passed on as prepaid principal to the holder of the mortgage.
The second phenomenon can be broadly characterized as “refinancing.” Strictly defined, a refinancing occurs when obligors prepay their loans in the absence of the sale or destruction of the underlying property. Refinancings are often undertaken by borrowers in order to lower the loan’s note rate and reduce the monthly payment on their mortgage. This type of transaction, referred to as a rate-and-term refinancing, has normally taken place when borrowers perceive that they can reduce their interest costs or their monthly mortgage payment by taking out a new loan. To borrow a term from the option market, the borrower’s existing loan in this case is considered “in-the-money.” Loans where borrowers are not able to improve their monthly cash flow situation are considered “out-of-the-money.”
Another related form ...