Loan Prepayment Option Valuation

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For a real estate investor, it’s important to understand how valuable a loan refinancing option is, which can be assessed using the Black-Scholes financial options pricing model.

For example, on a $100,000, 10-year mortgage loan, the value of this option came out to be $32,600. This represents the value of the borrower’s asset, which is reflected in the right to pay off the loan if interest rates drop in the market.

In general, the higher the expected volatility of interest rates, the more valuable the refinancing option is. Additionally, the higher the cost of refinancing and approval of a new loan, the lower the value of this option.

The graph also shows how the value of the option changes as market interest rates change and as time passes from the loan origination.

Notice that:

• The lower the interest rates after the loan is taken, the more valuable the option becomes, and the higher the chances of refinancing.
• The closer the loan repayment date gets, the less valuable the option becomes.

It’s important to understand that refinancing provides a specific benefit, and the original asset as an option disappears. However, part of this loss is replaced by the new loan’s option, which includes the potential for further interest rate decreases.

There are many people who take out loans and then don’t pay attention to what’s happening in the interest rate market… this is the same as giving up on this option.

Loan Prepayment Option Pricing Excel

Source initiated from:

Commercial Real Estate Analysis and Investments, D. M. Geltner, N. G. Miller, J. Clayton, P. Eichholtz

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