Lenders use a prepayment model to predict the likelihood of a borrower paying off a loan early. Prepayment models allow lenders to combine formulas with projected interest-rate fluctuations and market movement to estimate the amount of future loan payments by borrowers.
Prepayment models may be used with any loan or debt, but are most common with mortgage loans. A premature return on a lender’s investment generates less profit for them, so an accurate prepayment model is a valuable tool to assess risk and prevent loss.
For borrowers, understanding how a prepayment model works will help them know what to look for when taking on a loan, avoid prepayment penalties, and decide if it is okay to refinance.
Definition and Example of a Prepayment Model
“Prepayment models help predict the level of prepayments that a servicer could face, better preparing it for market movement and various economic shocks,” said Joseph Ellison, vice president of capital markets at Veterans United Home Loans.
Through mathematical formulas and historical prepayment analysis, prepayment models allow lenders to predict the future prepayment of loans or a loan portfolio based on interest-rate fluctuations.
Since lenders make most of their money from interest, they use prepayment models to evaluate their level of risk and profits. Interest-rate changes tend to drive the likelihood of prepayment. When interest rates drop, a borrower’s chance of refinancing their current mortgage to one with a lower interest rate increases.
Without an accurate prepayment model in place, lenders may lose money when borrowers move their debts to another provider. However, an efficient prepayment model can adequately predict the likelihood of prepayment and keep lenders’ profits within margin.
When a borrower commits to repay a loan or debt, they usually agree on an established monthly installment repayment plan with a set cost and interest rate. Lenders rely on these fixed monthly payments for cash flow and profits. Therefore, when a borrower overpays or makes a payment for more than one installment in advance, it will be reflected in the lender’s monthly profit and loss statement. With a prepayment model, though, lenders can anticipate a certain prepayment level so there’s not a significant impact on their bottom line.
How Does a Prepayment Model Work?
Lenders and investors apply a prepayment model to measure their risk when purchasing a loan or pool of loans. Some models standardize prepayment risk while others try to predict future rates, borrower behavior, and seasonality.
“Think of it as a retailer assuming losses to theft. They need to account for the expected rate of theft by charging a higher retail price to avoid operating at a loss,” John Li, co-founder and CTO at Fig Loans, told the Balance via email.
“A prepayment model can take a few different approaches because they all assume a different pattern of prepayments based on likely scenarios. From there, they calculate what the likely prepayment rate would be so they can design debt products that will help relieve the loss and keep the business profitable,” Li said.
To calculate a prepayment model, lenders generally figure a zero payment assumption, which means no early prepayments are made at the beginning of the loan. This factors in probable scenarios, such as new homeowners being less likely to move, refinance, or make extra payments shortly after taking out a loan. A zero payment assumption is a commonly established baseline for comparison in many prepayment models.
Prepayments help borrowers pay off debt earlier; however, they are disadvantageous to lenders and investors, especially when interest rates are low. To avoid the risk of multiple loans in a pool being refinanced simultaneously, some lenders may charge a prepayment penalty fee.
For example, credit cards and student loans generally allow for prepayments. In contrast, some auto and mortgage loans include a prepayment penalty clause if you pay off your loan early or overpay. In the case of mortgages, the penalty fee typically only applies if you pay off the entire mortgage balance within a specific period of time, which is generally three or five years.
Lenders use this tactic to discourage borrowers from paying off their debt entirely or putting a lump sum down on it. Prepayment penalties are usually agreed upon during loan contracts or closing, so be sure to read the details of your contract thoroughly before agreeing on the loan.
Types of Prepayment Models
Lenders use a variety of prepayment models to calculate and measure prepayment risk. As a result, there are many different models and prepayment rates from which to choose.
Learn about the three most common prepayment models, below.
Single Monthly Mortality (SMM)
The SMM rate is the amount of outstanding mortgage loan principal balance that is prepaid in a month. To calculate the SMM, you would divide the total prepayments by the principal balance at the beginning of the month, minus scheduled principal payments.
Conditional Prepayment Rate or Constant Prepayment Rate
This model is similar to the single monthly mortality model, except that it expresses the prepayment percentage as an annually compounded rate. It is the outstanding loan principal that is prepaid in a year based on the SMM. It is the simple average of the SMM for 12 months.
Some models rely on a simple baseline, while others include complex factors. Some investment banks develop in-house models. Regardless of the model used, most lenders assume a gradual rise in prepayment as the loan ages.
Public Securities Association (PSA) Prepayment Model
This is the most famous prepayment model and the one from which most other models derive their baselines. This model specifies a prepayment percentage for each month in the life of the mortgage or loan, expressed on an annualized basis.
It works by assuming a gradual rise in prepayments for the first 30 months of a loan. After that, prepayment estimates are at their highest until the end of the loan. To be more specific, the PSA begins with a CPR of 0.2% in the first month following origination, and adds an additional 0.2% a month until the 30th month. After the 30th month, the PSA assumes a 6% CPR rate for the remaining balance.
- A prepayment model allows investors to estimate the likelihood of borrowers paying off a debt early.
- Prepayment models use historical analysis and mathematical formulas to predict interest-rate changes that could influence borrower prepayment.
- Prepayment models are most commonly used with mortgage pool loans and mortgage-backed securities.
- The Public Securities Association Prepayment Model is the most common model. It serves as the standard baseline for many prepayment models.