Optimal Mortgage Refinancing with Stochastic Interest Rates

Abstract

The purpose of this paper is to develop a dynamic model of mortgage refinancing in a contingent claim framework that simultaneously solves for the borrower's optimal mortgage refinancing strategy, the value of the refinancing call option, the value of the mortgage liability to the borrower, and the market (lender) value of the fixed‐rate contract. We also calculate the minimum differential between the contract rate on the existing mortgage and the current interest rate that is required to trigger an optimal mortgage refinancing.