Penalty interest rates, LTV constraints, and screening laxity in mortgage markets

This study investigates the economic role of penalty interest rates with respect to lenders’ incentive structure toward borrower defaults in mortgage markets. We model a bank’s credit rationing problem with two strategies, screening out bad loans and risk-based pricing, and show that the bank’s strategies vary with the environment of penalty interest rates and loan-to-value (LTV) ratios. As low LTV ratios indicate sufficient buffer between the debt and the collateral value, the lenders could be over-compensated from the default if they are allowed to charge a penalty interest rate exceeding the administrative cost of default. Our findings suggest that tightening LTV constraints while leaving regulations on penalty interest rates relaxed can unexpectedly undermine lenders’ voluntary willingness to monitor and prevent mortgage defaults.