Tax arbitrage incentives for mortgage prepayment behavior

Evidence from Dutch micro data

The aim of this paper is to analyze to what extend prepayment behavior of households is driven by financial incentives. As taxes on financial wealth are an important component of these incentives, we are able to estimate the sensitivity of wealth tax revenues to changes in the effective tax rate – through the channel of prepayment. The Dutch case is particularly interesting because on the one hand households can deduct mortgage interest prepayments from taxes on labor income, while on the other hand housing wealth is exempt from personal wealth taxation. This paper uses a novel approach by deriving the differential in individual contractual (fixed term) mortgage interest rates and individual short-term interest rates on savings accounts, taking also into account various types of taxation. This differential is used as a determinant for the prepayment probability within a panel of Dutch households. The estimated impact of the tax rate differential on the prepayment probability is used to determine tax elasticities. To exploit the panel structure of our data and to account for endogeneity of the prepayment value, we apply the Arellano-Bond generalized method of moments (GMM) estimator.


This paper exploits a unique set of Dutch micro data to analyze the response in prepayment behavior to changes in incentives for prepaying. The paper shows that the effect of mortgage interest rates on the value of prepaying a mortgage (also taking taxes and returns on savings into account) is equivalent to a change in the tax rate on financial wealth. This feature is used to estimate tax elasticities (i.e. the elasticity of changes in wealth tax revenues resulting from changes in prepayment with respect to the wealth tax rate). Using a linear probability model with the Arellano-Bond estimator, the paper finds that the prepayment probability increases by 0.5% point if the prepayment value as a fraction of the mortgage increases by 1% point. The effect is about six times as high for households owning more than 200,000 euro and it is not statistically significant for households with little financial wealth.

In the 1980s and 1990s it was generally unfavorable for Dutch households to prepay mortgages, because of the high interest rates and the generous mortgage interest deductibility. The most common Dutch mortgages have fixed interest rates for at least 5 to 20 years, which are expensive to refinance.1 Due to the decline in interest rates in the 2000s, especially in the aftermath of the great recession, prepayment has become optimal for many households maximizing their financial wealth.2 The reason is that the differential between (existing) contractual mortgage interest rates and the returns on savings has become much larger. This is especially the case for households paying a personal wealth tax3, because the tax system exempts housing wealth and the corresponding mortgage from this tax. Mortgage prepayment could thus be a major instrument to reduce the burden of personal wealth taxes for households. Decreased inflation has also made prepaying more attractive, because low inflation reduces the benefits of deducting the nominal interest rate expenses.


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