Origination Channel, Prepayment Penalties and Default

This paper presents evidence that non-bank-originated subprime mortgages have a higher probability of default than bank-originated subprime mortgages, but only for loans with prepayment penalties. Evidence also indicates that non-banks price prepayment penalties less favorably to borrowers than banks do, and non-banks originate disproportionately more loans with prepayment penalties in locales with less financially sophisticated borrowers. State anti-predatory lending law provisions restricting the use of prepayment penalties eliminate the elevated default risk of non-bank originations relative to bank originations. These findings are consistent with incentives generated by non-bank compensation via yield spread premiums on loans with prepayment penalties.