The purpose of this paper is to study the factors that affect prepayment of fixed-rate home equity loans. While most studies of prepayment have focused on conventional primary mortgages, few published studies have analyzed the prepayment of home equity loans, especially at the loan level. In this paper, we study the prepayment behavior of home equity loans empirically using a large loan-level data set.

Home equity loans have changed over the past 10 years. Prior to the mid-1990s, home equity loans generally referred to second-lien mortgage loans that were originated to consolidate debt or finance large expenditures, such as education, home improvement or medical treatment. Although home equity loans may have a fixed or floating rate or a hybrid of the two, fixed rate home equity loans dominated issuance during much of the mid-1990s. During this period, home equity loans usually took the form of home equity lines of credit, and were usually open-ended. After the mid-1990s, the home equity loan market moved towards longer (and fixed) terms, larger loan balances, and more first liens (Schorin, Heins, and Prasad 2003). The home equity loans studied in this paper were issued between 1995 and 1998. Given this timing, the loans have some features of both the older and the newer characteristics of home equity loans; they are 15-year, fixed-rate second-lien mortgages to both prime and sub-prime borrowers.

In the analysis of prepayment of primary mortgages, both theoretical models and empirical studies suggest that market interest rate changes, loan size, loan-to-value ratios, borrower credit and other variables have a significant impact on prepayment behavior. There is no a priori reason to expect different prepayment behavior for home equity loans. However, smaller loan sizes, higher coupon rates and borrower motivation for taking out home equity loans may affect prepayment behavior.

The data set used in the analysis in this paper contains 54,999 fixed-rate home equity loans originated by a major US bank. The detailed loan-level data provide a good opportunity to assess which factors affect home equity loan prepayment. In this paper, we focus on variables such as interest rate changes, trends in interest rate changes, loan size, and loan-to-value ratios that previous studies have found to affect the prepayment of primary mortgages. Because home equity loans are similar to other mortgage loans in many ways, we expect these variables to also influence the prepayment of home equity loans. In addition, we examine some monthly payment patterns for home equity loans to see whether delinquencies are an indicator of the probability of home equity loan prepayment.

To investigate the impact of borrower creditworthiness on home equity loan prepayment, we include FICO scores as an independent variable. 1 The FICO score is also used to decide whether a borrower qualifies for a prime loan. In this paper, we create two sub-samples based on borrower FICO scores to investigate whether creditworthy borrowers are more likely to take advantage of lower interest rates.

Empirical results obtained from proportional hazard models show that the prepayment of home equity loans is sensitive to market interest rate changes, original loan sizes, FICO scores and delinquencies. However, the loan-to-value ratio has little impact on the prepayment of home equity loans. We find that trends in interest rate changes have very significant impacts on prepayment. When borrowers expect market interest rates to decline further, they will wait to prepay their home equity loans even when the loans are already “in the money.” We also find that previous delinquencies affect the likelihood of prepayment when home equity loans are “out of the money.” Empirical results obtained from the sub-samples show that prime borrowers are more sensitive to changes in interest rates than are sub-prime borrowers.

The next section of the paper reviews the existing literature on prepayment and discusses major factors expected to affect prepayment behavior for home equity loans. Following descriptions of the data and methodology, we report and discuss the empirical results. We then conclude with a summary of the findings.

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