Lester Freeman
Prepayment risk is the risk that a borrower will pay off a loan earlier than expected. This is a risk for mortgage lenders and mortgage-backed securities (MBS) investors, as they will not receive as much interest as they had anticipated. Prepayment can occur when a borrower refinances a mortgage or sells their home.
| Characteristics | Values |
|---|---|
| Definition | Prepayment risk is the risk that a borrower will pay off a loan earlier than expected. |
| Example | John Doe borrows $300,000 to buy a house in Phoenix. The loan is a 30-year mortgage at 5% interest. The lender, Bank XYZ, expects to make, say, $100,000 in interest over the life of the loan. John lives in the house for five years and makes his payments on time every month. However, in year six, he gets a job offer in Philadelphia and decides to move there. Accordingly, he sells his house. At the closing, the buyer gives John $500,000 for his house. |
| Who is affected | Lenders and investors |
| Types of investment affected | Mortgage-backed securities (MBS), pass-through securities |
What You'll Learn
Mortgage lenders and mortgage-backed securities (MBS) investors
Prepayment risk is the risk that a borrower will pay off a loan earlier than expected. This is a risk for mortgage lenders and mortgage-backed securities (MBS) investors, who will lose out on interest payments they had counted on.
Mortgage lenders and MBS investors anticipate returns based on interest being paid over the life of the mortgage. When a borrower pays off their mortgage early, the lender and investors miss out on this interest. For example, a borrower may decide to sell their home and pay off their loan early, or they may refinance their mortgage at a lower interest rate.
MBS investors can manage prepayment risk by analysing the prepayment behaviour of the underlying loans or MBS and considering investment strategies such as using securities with prepayment protection or adjusting their portfolio duration.
For mortgage lenders, there is not much downside to a borrower paying off their loan early, and most of the time there is no penalty for doing so. However, it does mean that the lender will receive less interest overall.
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Pass-through securities
Prepayment risk is the risk that a borrower will pay off a loan earlier than expected. This can happen when a borrower refinances a mortgage or sells their home. For example, if someone borrows $300,000 to buy a house with a 30-year mortgage at 5% interest, the lender expects to make around $100,000 in interest over the life of the loan. However, if the borrower sells the house after five years, the lender will miss out on 25 years' worth of interest payments.
Mortgage-backed securities (MBS) are another investment product with prepayment risk. MBS are bundles of mortgages that are sold to investors. The returns on MBS are anticipated based on interest being paid over the life of the mortgages. If a person pays off their mortgage early or defaults, the investor loses out on the expected interest payments.
Investors can manage prepayment risk by analysing the prepayment behaviour of the underlying loans or MBS and considering investment strategies such as using securities with prepayment protection or adjusting their portfolio duration. For example, an investor could choose to invest in securities that offer prepayment protection, which guarantees a minimum number of interest payments even if the borrower pays off the loan early. Alternatively, an investor could adjust their portfolio duration by investing in a mix of short-term and long-term securities to reduce the overall risk of prepayment.
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Prepayment protection
Mortgage lenders and investors in mortgage-backed securities (MBS) are particularly vulnerable to prepayment risk. MBS returns are based on interest being paid over the life of the mortgage, so if a borrower pays off their mortgage early, the investor loses out on those interest payments.
It's important to note that prepayment protection strategies may not always be effective, as they depend on the prepayment behaviour of borrowers, which can be unpredictable. Additionally, the availability and effectiveness of prepayment protection strategies may vary depending on the specific investment product and market conditions.
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Refinancing a mortgage
Prepayment risk is the risk that a borrower will pay off a loan earlier than expected. This can happen when a borrower refinances a mortgage, sells their home, or makes a prepayment to their bank.
For example, imagine that you take out a $300,000 mortgage with a 30-year term and a 5% interest rate. The lender expects to make around $100,000 in interest over the life of the loan. However, after five years, you decide to refinance your mortgage with another lender who is offering a lower interest rate of 4%. By refinancing, you will save money on interest payments over the remaining 25 years of the loan. But the original lender will lose out on the anticipated interest income.
Investors who buy mortgages bundled into mortgage-backed securities (MBS) are also exposed to prepayment risk. MBS are investments that are backed by a group of mortgages, and the returns on these investments are based on the interest payments made on the mortgages. When a borrower pays off their mortgage early, either through refinancing or by selling their home, the investors in MBS lose out on the anticipated interest income.
To manage prepayment risk, investors can analyse the prepayment behaviour of the underlying loans or MBS and consider investment strategies such as using securities with prepayment protection or adjusting their portfolio duration.
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Defaulting on a loan
Prepayment risk can also occur when a borrower refinances a mortgage or sells their home. In this case, the borrower may pay off the loan early, which can also result in a loss of interest payments for the lender. It is important for investors to be aware of the risks associated with MBS and to consider the potential for prepayment when deciding on their investment strategy.
One way to manage prepayment risk is to analyse the prepayment behaviour of the underlying loans or MBS. Investors can also consider using securities with prepayment protection or adjusting their portfolio duration. For example, an investor may choose to invest in a loan with a longer term or a higher interest rate to reduce the risk of prepayment.
It is also important to consider the borrower's ability to repay the loan. If a borrower is unable to make their monthly payments, they may default on the loan, which can result in a financial loss for the lender. In this case, the lender may be able to recover some of the losses through foreclosure or other legal means. However, this process can be costly and time-consuming, and the lender may not be able to recover the full amount owed.
Overall, defaulting on a loan is a significant risk for lenders and investors, and it is important to carefully consider the potential consequences before extending or investing in a loan. By understanding the risks associated with prepayment, lenders and investors can make more informed decisions and develop strategies to mitigate potential losses.
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Frequently asked questions
Prepayment risk is the risk that a borrower will pay off a loan earlier than expected. This means that the lender or investor will not receive as much interest as they had anticipated.
Investment products that have prepayment risk include mortgage-backed securities (MBS) and pass-through securities.
Investors can manage prepayment risk by analysing the prepayment behaviour of the underlying loans or MBS, considering investment strategies such as using securities with prepayment protection or adjusting their portfolio duration.
