Prepayment
Encyclopedia
Prepayment is early repayment of a loan by a borrower.
In the case of a mortgage-backed security
(MBS), prepayment is perceived as a risk
, because mortgage debt
s are often paid off early in order to incur lower total interest
payments through cheaper refinancing. The new financing may be cheaper because the borrower's credit rating
has improved or because interest rates are lower, but in either case, the payments that would have been made to the MBS investor would be above market
rates. Redeeming such loans early through prepayment reduces the upside of credit & interest rate
variance in an MBS. As these variance
s head lower (interest rates rises or creditworthiness declines) borrowers lose the incentive to refinance (since the fixed mortgage payments are now at below-market rates). The fact that MBS-holders are exposed to downside prepayment risk, but rarely benefit from it, means that these bonds must pay a slightly higher interest rate than similar bonds without prepayment risk, to be attractive investments. (This is the option-adjusted spread
.)
To compensate for the prepayment risk (which is a reinvestment risk
), prepayment penalty clause is often included into the loan contract.
There are often soft prepayment terms versus hard prepayment terms. Soft prepayment terms can allow you prepayment without penalty under the terms of selling the home. Hard prepayment does not allow any exceptions without penalty. Bond issuers can overcome prepayment risks by issuing what are called super sinker bonds. Super sinker bonds are a bond with long-term coupons but a short-term maturity. Super sinkers are usually home-financing bonds that give bondholders their principal back right away if homeowners prepay their mortgages. In other words, mortgage prepayments are used to retire a specified maturity. Super sinkers are likely to be paid off in a relatively short time. As a result, holders may receive the higher long-term yield after only a short period.
Prepayment speeds can be expressed in SMM (single monthly mortality), CPR (collateral prepayment rate) or multiples of PSA.
In the case of a mortgage-backed security
Mortgage-backed security
A mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
(MBS), prepayment is perceived as a risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
, because mortgage debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
s are often paid off early in order to incur lower total interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
payments through cheaper refinancing. The new financing may be cheaper because the borrower's credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
has improved or because interest rates are lower, but in either case, the payments that would have been made to the MBS investor would be above market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
rates. Redeeming such loans early through prepayment reduces the upside of credit & interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
variance in an MBS. As these variance
Variance
In probability theory and statistics, the variance is a measure of how far a set of numbers is spread out. It is one of several descriptors of a probability distribution, describing how far the numbers lie from the mean . In particular, the variance is one of the moments of a distribution...
s head lower (interest rates rises or creditworthiness declines) borrowers lose the incentive to refinance (since the fixed mortgage payments are now at below-market rates). The fact that MBS-holders are exposed to downside prepayment risk, but rarely benefit from it, means that these bonds must pay a slightly higher interest rate than similar bonds without prepayment risk, to be attractive investments. (This is the option-adjusted spread
Option-adjusted spread
Option adjusted spread is the flat spread which has to be added to the treasury yield curve in a pricing model to discount a security payment to match its market price. OAS is hence model dependent. This concept can be applied to a mortgage-backed security , option, bond and any other interest...
.)
To compensate for the prepayment risk (which is a reinvestment risk
Reinvestment risk
Reinvestment risk is one of the main genres of financial risk. The term describes the risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being there might not be a similarly attractive investment available...
), prepayment penalty clause is often included into the loan contract.
There are often soft prepayment terms versus hard prepayment terms. Soft prepayment terms can allow you prepayment without penalty under the terms of selling the home. Hard prepayment does not allow any exceptions without penalty. Bond issuers can overcome prepayment risks by issuing what are called super sinker bonds. Super sinker bonds are a bond with long-term coupons but a short-term maturity. Super sinkers are usually home-financing bonds that give bondholders their principal back right away if homeowners prepay their mortgages. In other words, mortgage prepayments are used to retire a specified maturity. Super sinkers are likely to be paid off in a relatively short time. As a result, holders may receive the higher long-term yield after only a short period.
Prepayment speeds can be expressed in SMM (single monthly mortality), CPR (collateral prepayment rate) or multiples of PSA.