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 (MBS) investors that people will pay their loans off earlier than the full term. This prevents them from getting interest payments for the long amount of time as they'd counted on.

Some people can face financial penalties when they sell their homes or refinance 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 if you decide to pay off your home early, and most of the time there is no penalty if you don't do it all at once. For instance, you may pay it off early by paying a little extra toward principal each month. But for people who've invested in your loan, it means less money for them.

Third parties, such as banks or agencies like Fannie Mae or Freddie Mac, buy home loans and bundle them together in mortgage-backed securities. People who invest in MBS, also known as mortgage pass-throughs, will get returns based on the principal and interest payments from borrowers over the lives of the loans.

For instance, the entity that buys a mortgage will receive the interest payments if a buyer takes out a $200,000 home loan with a 30-year fixed rate of 5%. The prepayment risk is that people will pay off their mortgages early, thus keeping the purchaser from getting all those future payments.

MBS also come with risk because the homeowner might default on the loan.

Prepayment risk is one potential pitfall of investing in MBS. People who invest 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 events under which a person might prepay their home loan:

  • They choose to refinance their mortgage to get a lower rate.
  • They sell the home, so the mortgage must be paid off and cleared to transfer a clear title to the new owner.
  • The house is destroyed, so the mortgage is retired when the insurer pays the homeowners insurance claim.

You will want to see loans paid back in full if you're investing in MBS, 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 if you have invested in it.

Finding the Prepayment Risk

Some data has been gathered to help you see how likely it is that a loan or a pool of loans will be paid off early and what their overall return might be.

The conditional prepayment rate (CPR) is figured as a percentage. There's a belief that 8% of the loans in a given pool will prepay over the next year if you have a CPR of 8%. CPR is most often found based on past data and the makeup of the loan pool. There might be certain people who tend to pay off loans early while others do not.

CPR is also based on projected changes in rates. The CPR might be higher if rates are expected to drop because more people might choose to refinance their home loans to get that lower rate. Prepayment rates topped more than 70% in 2002 because interest rates fell during that period. Rising rates, on the other hand, can reduce the risk of a loan being paid off early.

You can find 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 MBS or similar investments using CPR and SMM. People who invest in them must decide how much of a return they're looking for and know that a higher rate of return might also come with a higher risk of default.

Most of the time, it's not worth the effort for people to research and invest in individual MBS. Still, it might make sense to hold some mutual funds that contain MBS as part of a larger mix of corporate or government bonds.

Most discount brokers offer MBS 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 know the benefits and risks of MBS to reduce risk and get the best returns.

Key Takeaways

  • Lenders and investors run the risk of prepayment by borrowers when they buy mortgages bundled into MBS.
  • Returns on MBS are anticipated based on interest being paid over the life of mortgages, and this money is lost when a person pays the mortgage off early or defaults.
  • Prepayment can also occur when a borrower refinances a mortgage or sells the home.
  • Investors should decide on the return they're looking for and be aware 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.