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What is Prepayment Risk?
Prepayment risk refers to the risk that the principal amount (or a portion of the principal amount) outstanding on a loan is prematurely paid back. In other words, prepayment risk is the risk of early repayment of a loan by a borrower.
Understanding Prepayment Risk
Prepayment risk may sound counter-intuitive in that repaying a loan in a shorter period of time is considered a risk. However, to a lender, it may be preferable to have a loan outstanding for a longer period of time. To understand prepayment risk, we introduce an example.
Consider a loan with a face value of $1,000. The loan has a 10% interest rate on the face value of the loan. The borrower is to make annual interest payments over a period of three years. As such, the lender would be receiving $1,300 over the life of the loan. The loan’s payment schedule is illustrated below:
Next, assume that the borrower has the option to repay the face value amount before the end of three years. In this scenario, the borrower can theoretically repay the face value of $1,000 at the end of Year 1 and end up not having to pay interest in Years 2 and 3 (due to the face value being repaid at the end of Year 1). In doing so, the lender would only end up receiving $100 in profit on the loan. The payment schedule in this scenario is illustrated below:
As such, prepayment risk is the risk that the borrower repays the outstanding principal amount (or a portion of the outstanding principal amount) prematurely and, in turn, causes the lender to receive less in interest payments.
Prepayment Risk in Mortgage-backed Securities
Mortgage-backed securities (MBS) commonly face prepayment risk. A mortgage-backed security is made up of a bundle of home loans that investors can purchase. Investors in mortgage-backed securities collect interest payments made by the underlying home loans. As such, when the homeowners repay their loans earlier than expected, investors in mortgage-backed securities face the risk of having lower future interest payments generated from the underlying home loans.
To mitigate the prepayment risk faced by investors in mortgage-backed securities, prepayment penalties are commonly imposed on homeowners who repay their home loans earlier than expected.
Interest Rates and Prepayment Risk
Although there are numerous factors that can cause a borrower to repay their loan earlier than expected, the driving factor tends to be changes in interest rates.
For example, consider a homeowner that takes out a floating-rate home loan (i.e., the interest rate on the home loan increases as market interest rate increases and vice versa).
If interest rates decrease, the homeowner will have an incentive to refinance the floating-rate home loan into a fixed-rate home loan. In this scenario, the potential for refinancing the home loan will increase the prepayment risk for the original lender.
If interest rates increase, the homeowner will have an incentive to repay the home loan more quickly to avoid higher future interest payments. In this scenario, making principal payments earlier will reduce future interest payments and increase the prepayment risk for the lender.
As such, changes in interest rates play a key role in increasing the prepayment risk faced by lenders.
Practical Example
A homeowner takes out a mortgage at an interest rate of 15%. At the time of taking out a mortgage, the market interest rate was 15%. Two years later, the market interest rate is 10%. Explain the prepayment risk, if any, faced by the lender.
Solution: The lender faces prepayment risk on the mortgage due to the change in market interest rates from 15% to 10%. The homeowner has an incentive, assuming that there are no prepayment penalties or refinancing fees, to refinance the mortgage from an interest rate of 15% to an interest rate closer to the current market interest rate of 10%. In doing so, the lender will forego the interest payments (at the higher interest rate) that would have been made by the homeowner over the life of the mortgage.
Additional Resources
CFI offers the Commercial Banking & Credit Analyst (CBCA®) certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant CFI resources below:
Prepayment risk is the risk involved with the premature return of principal on a fixed-income security. When prepayment occurs, investors must reinvest at current market interest rates, which are usually substantially lower. Prepayment risk mostly affects corporate bonds and mortgage-backed securities
mortgage-backed securities
Mortgage-backed securities (MBS) are investments like bonds. Each MBS is a share in of a bundle of home loans and other real estate debt bought from the banks or government entities that issued them. Investors in mortgage-backed securities receive periodic payments like bond coupon payments.
A prepayment is a payment that you make before you receive goods or services, or before a debt is due. If a borrower makes prepayments, the loan balance declines more rapidly than would otherwise be possible.
Prepayment risk may sound counter-intuitive in that repaying a loan in a shorter period of time is considered a risk. However, to a lender, it may be preferable to have a loan outstanding for a longer period of time.
In the case of a mortgage-backed security (MBS), prepayment is perceived as a financial risk—sometimes known as "call risk"—because mortgage loans are often paid off early in order to incur lower interest payments through cheaper refinancing.
The most common metric used to measure prepayment speeds is the conditional prepayment rate, which is the percentage of principal expected to be received ahead of schedule per year. However, borrowers make mortgage payments on a monthly basis and, as such, prepayment rates are typically reported each month.
Put simply, any time you pay a bill, operating expense, or non-operating expense before it's due, you're looking at a prepayment. There are a vast range of debts and obligations that businesses may choose to settle in advance, such as wages, rent, or revolving lines of credit.
As lenders may risk losing interest payments due to prepayment, the industry establishes two risk mitigation strategies—lockout periods and prepayment penalties—into commercial mortgage contracts, minimizing potential losses.
Firstly, if the prepayment in full can be done relatively early into the tenure of the loan, a customer tends to save a lot on the interest. A personal loan generally has a lock in of about one year after which the entire outstanding amount can be prepaid.
Prepayment risk can take one of these two forms: contraction risk: the risk that interest rates decline. Homeowners will then refinance at the available lower interest rates. extension risk: the risk that when interest rates rise, prepayments will be lower than expected.
Whereas contraction risk happens when borrowers pre-pay a loan, shortening its duration, extension risk occurs when they do the opposite—they defer loan payments, increasing the length of the loan.
If your prepayment meter has run out of credit and your supply is off, you may need to repay any 'Emergency Credit', 'Friendly Credit' or any outstanding amount owed, before your supply will come back on. You may also need to account for any debt repayment plan that has been agreed.
Prepayment risk is an important aspect of credit risk that can have a significant impact on credit quality. Prepayment risk refers to the risk that borrowers will pay off their loans early, which can result in a loss of interest income for the lender.
The prepayment risk is highest for fixed-income securities, such as callable bonds and mortgage-backed securities (MBS). Bonds with prepayment risk often have prepayment penalties.
To guard against prepayment risk, the enterprises use written option derivatives. Written options: The enterprises pay a premium to a financial institution in exchange for the option to have it pay them if interest rates fall below an agreed-upon rate.
Change in Duration → The risk of prepayment can affect the duration of a mortgage-backed security (MBS). Duration measures the sensitivity of the price of debt obligation to changes in interest rates.
A prepayment policy allows you to charge guests for their reservations in advance. You can set up an automatic prepayment policy in the extranet if you accept credit cards, or your guests can pay via bank transfer.
Prepaid rent is a lease payment made for a future period. A company makes a cash payment, but the rent expense has not yet been incurred so the company has prepaid rent to record. Prepaid rent is an asset – the prepaid amount can be used by the entity in the future to reduce rent expense when incurred in the future.
When you prepay your loan, you are wiping out your financial burden which also has a positive impact on your credit score. As outstanding loans are linked to your credit score, prepayment of personal loans whether partially or in full will automatically result in your credit score going up.
Introduction: My name is Van Hayes, I am a thankful, friendly, smiling, calm, powerful, fine, enthusiastic person who loves writing and wants to share my knowledge and understanding with you.
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