What Is Prepayment Risk?

Definition and Examples of Prepayment Risk

Couple at home toasting their paid-off mortgage with wine
••• Klaus Vedfelt / Getty Images

Prepayment is a risk for mortgage lenders and mortgage-backed securities investors that borrowers will pay their loans off earlier than the full term. This prevents them from collecting interest payments for an extended period of time as they'd counted on.

Borrowers can face financial penalties when they sell their homes or refinance, thus retiring the mortgage within a certain period of time, usually three to five years after you take out the loan.

What Is a Prepayment Risk?

There’s not much downside in most cases for borrowers who pay their houses off early, and there's generally no penalty if you do it incrementally, paying a little extra toward principal each month. But it's a decidedly negative event for anyone who has invested in your mortgage.

Third parties, such as banks or government agencies like Fannie Mae or Freddie Mac, commonly purchase mortgages and bundle them together in mortgage-backed securities. Anyone who invests in a mortgage-backed security, also known as a mortgage pass-through, will receive payments based on the principal and interest payments from those mortgages over the lives of the loans.

For example, the entity that purchases a mortgage will receive the interest payments if a homebuyer takes out a $200,000 mortgage loan with a 30-year fixed interest rate at 5%. The prepayment risk is that the borrower will pay off the mortgage early, thus preventing the purchaser from getting all those anticipated interest payments.

Mortgage-based securities also come with risk because the homeowner might default on the loan.

Prepayment risk is one potential pitfall to investing in mortgage-backed securities. Investors in U.S. Treasuries or corporate bonds don’t face this risk because prepayments aren’t allowed.

How Does Prepayment Work?

There are a number of circumstances under which a person might prepay their mortgage:

  • They choose to refinance their mortgage to take advantage of a lower interest rate.
  • They sell the home, so the mortgage must be paid off and cleared to transfer clear title to the property to the buyer.
  • The house is destroyed, so an insurer ends up retiring the mortgage when it pays the resulting homeowners insurance claim.

You ideally want to see loans paid back in full if you're investing in mortgage-backed securities, but not too quickly. It’s best to see a 30-year mortgage paid back in 30 years because you'll not only recoup your investment, but you get all those interest payments along the way.

A loan that's paid off early results in a lower return for you.

Calculating Prepayment Risk

Some data has been collected to help investors understand how likely it is that a loan or a pool of loans will be paid off early, and what their overall expected return might be.

The conditional prepayment rate (CPR) is calculated as a percentage. There’s an expectation that 8% of the loans in a given pool will prepay over the next year if you have a CPR 8%. CPR is generally calculated based on historical data and the characteristics of the underlying loan pool. There might be certain borrowers who tend to pay off loans early while others do not.

CPR is additionally based on projected changes in interest rates. The CPR might be higher if interest rates are expected to drop because more people might choose to refinance their mortgages to take advantage of this. Prepayment rates topped more than 70% in 2002 because interest rates fell during that period. Rising interest rates, on the other hand, can reduce prepayment risk.

You can calculate the single monthly mortality rate (SMM) or prepayment speed using the CPR. The SMM helps you understand the monthly rates of prepayment. It's calculated like this:

SMM = 1 – (1 – CPR) to the 1/12th power

In this case, an 8% CPR would result in an SMM of 0.69% This is the percentage of a month's scheduled principal balances that have been repaid.

Should I Invest in Mortgage-Backed Securities?

Banks and agencies can provide an expected rate of return on mortgage-backed security or similar investments using CPR and SMM. Investors must decide how much of a return they're looking for and understand that a higher rate of return might also come with a higher risk of default.

It’s generally not worth the effort for everyday investors to research and invest in individual mortgage-backed securities. It might make sense, however, to hold some mutual funds that contain mortgage-backed securities as part of a larger mix of corporate or government bonds.

Most discount brokers offer mortgage-backed security mutual funds or exchange-traded funds, many of which include a mix of short-term and longer-term mortgages. These funds are often run by skilled managers who understand the benefits and risks of mortgage-backed securities to reduce risk and achieve the best returns.

Key Takeaways

  • Lenders and investors run the risk of prepayment by borrowers when they purchase mortgages bundled into mortgage-backed securities.
  • Returns on these securities are anticipated based on interest being collected over the life of mortgages, and this interest is lost when a borrower pays the mortgage off early or defaults.
  • Prepayment can also occur when a borrower refinances a mortgage or sells the home.
  • Investors should determine the return they're looking for and understand that a higher rate of return also comes with higher risk. 

NOTE: The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors.