Suppose I owe you a million dollars for 30-years at a fixed rate of 5%. If the prevailing rates are 5% or less (and you think I'll remain solvent), there's no real reason for you to take less than face value if I agree to pay it off now.
Suppose then prevailing rates go up to 10%. Now you have incentive to take less than a million dollars if I pay it off now. You could take the million bucks and lend it back out at 10% now, but you're stuck with 5% with me.
The question is "how much incentive/how much less would you rationally take?"
But the bank is in the position to “create money” to loan at 10% while also making that 5% on you. I don’t think it’s realistic to expect the bank to be interested in taking your (lower) payoff specifically to loan it at a higher rate.
They still have reserve requirements, meaning the total money they can lend out isn't infinite and therefore the money they lent to me they might wish to have back and lend it out to someone else at the higher rate.
> meaning the total money they can lend out isn't infinite and therefore the money they lent to me they might wish to have back and lend it out to someone else at the higher rate.
That's assuming they have someone else to lend it out to who is not only equally creditworthy, but equally creditworthy at the higher interest rate and therefore payment amount.
By that logic you would expect banks to create infinite money and drive interest rates down to 0.00001%. the fact that doesn't happen should hint that you've misunderstood how banks work
Depends how many people come back willing to sell their loans, and what that does to the liquidity position of the bank, and their current intentions regarding investment and the capital requirements to execute that.
It doesn't matter if the bank owns it or it's packaged in an MBS. Whoever owns it would be financially inventivized to let you pay off your loan at a discount and pocket the difference in reinvesting at a higher yield.
Suppose then prevailing rates go up to 10%. Now you have incentive to take less than a million dollars if I pay it off now. You could take the million bucks and lend it back out at 10% now, but you're stuck with 5% with me.
The question is "how much incentive/how much less would you rationally take?"