This paper, published in the UC Berkeley Working Papers on Housing and Urban Policy, explores the behavior of homeowners with mortgages, focusing on the exercise of mortgage prepayment and default options. The authors test the extent to which option theory can explain default and prepayment behavior, evaluate the importance of modeling both options simultaneously, and analyze the unobserved heterogeneity among borrowers. They present a unified model that considers the competing risks of mortgage termination by prepayment and default, treating them as dependent risks and estimating them jointly. The model also accounts for unobserved heterogeneity among borrowers, which is estimated simultaneously with the parameters and baseline hazards associated with prepayment and default functions. The results show that the option model, in its simplest form, does a good job of explaining default and prepayment behavior, but it is not sufficient on its own. The simultaneity of the options is crucial in explaining behavior, and unobserved heterogeneity among borrowers is significant. Ignoring this heterogeneity leads to serious errors in estimating prepayment behavior. The paper also discusses the importance of transaction costs and information asymmetry in the exercise of these options. The empirical analysis is based on individual mortgage history data from the Federal Home Loan Mortgage Corporation (Freddie Mac), covering 1,489,372 observations on single-family mortgage loans issued between 1976 and 1983. The analysis focuses on loans issued in 30 major metropolitan areas, with observations from the quarter of origination through the quarter of termination, maturation, or 1992:I for active loans. The key variables include measures of the financial value of the prepayment and default options, as well as other trigger events such as unemployment and divorce. The results show that financial motivation is paramount in governing prepayment and default behavior, but other factors like unemployment and divorce also play significant roles. The paper concludes by emphasizing the importance of considering both the interdependence of prepayment and default risks and the heterogeneity among borrowers in understanding mortgage behavior.This paper, published in the UC Berkeley Working Papers on Housing and Urban Policy, explores the behavior of homeowners with mortgages, focusing on the exercise of mortgage prepayment and default options. The authors test the extent to which option theory can explain default and prepayment behavior, evaluate the importance of modeling both options simultaneously, and analyze the unobserved heterogeneity among borrowers. They present a unified model that considers the competing risks of mortgage termination by prepayment and default, treating them as dependent risks and estimating them jointly. The model also accounts for unobserved heterogeneity among borrowers, which is estimated simultaneously with the parameters and baseline hazards associated with prepayment and default functions. The results show that the option model, in its simplest form, does a good job of explaining default and prepayment behavior, but it is not sufficient on its own. The simultaneity of the options is crucial in explaining behavior, and unobserved heterogeneity among borrowers is significant. Ignoring this heterogeneity leads to serious errors in estimating prepayment behavior. The paper also discusses the importance of transaction costs and information asymmetry in the exercise of these options. The empirical analysis is based on individual mortgage history data from the Federal Home Loan Mortgage Corporation (Freddie Mac), covering 1,489,372 observations on single-family mortgage loans issued between 1976 and 1983. The analysis focuses on loans issued in 30 major metropolitan areas, with observations from the quarter of origination through the quarter of termination, maturation, or 1992:I for active loans. The key variables include measures of the financial value of the prepayment and default options, as well as other trigger events such as unemployment and divorce. The results show that financial motivation is paramount in governing prepayment and default behavior, but other factors like unemployment and divorce also play significant roles. The paper concludes by emphasizing the importance of considering both the interdependence of prepayment and default risks and the heterogeneity among borrowers in understanding mortgage behavior.