Prepayment Option and the Interest Rate DifferentialBetween a Fixed- and Floating-Rate Mortgage Loan

A fixed-rate borrower has the option to pay off the loan after paying certain penalties. The borrower will do so only if the spot interest rate falls sufficiently below the contract rate. Assuming that the spot interest rate follows a mean-reverting process, this article finds that the fixed-rate borrower has a more valuable prepayment option such that the interest rate differential between a fixed- and a floating-rate loan expands when the term of the loan lasts longer, either the steady-state or initial spot interest rate is lower, penalties associated with prepayment are lower, or interest rates increase at an unpredictable rate. TOPICS:Fixed income and structured finance, options