Prepayment Risk
What Is Prepayment Risk?
Prepayment risk is the risk that a borrower will repay a loan earlier than expected, which can affect the returns of investors who receive interest payments from that loan. This risk is common in mortgage-backed securities and other loan-based investments.
When borrowers repay loans early, investors may receive their principal sooner than anticipated.
Why It Matters
Early repayment can reduce the total interest investors expected to earn. If interest rates fall, borrowers may refinance their loans, causing widespread prepayments that impact investment returns.
Prepayment risk is an important consideration for investors in mortgage-related securities.
How Prepayment Risk Works
Borrowers may repay loans early for several reasons:
- refinancing to obtain lower interest rates
- selling property tied to a mortgage
- making extra payments to eliminate debt faster
When this happens, investors who funded the loans lose future interest income.
Example
A homeowner refinances a mortgage when interest rates drop, causing early repayment of the original loan.
Prepayment Risk vs Interest Rate Risk
- Prepayment risk involves early loan repayment.
- Interest rate risk involves price fluctuations due to interest rate changes.
FAQs About Prepayment Risk
Which investments face the most prepayment risk?
Mortgage-backed securities often experience this risk.
Why does refinancing increase prepayment risk?
Lower interest rates encourage borrowers to replace older loans.
Can investors reduce prepayment risk?
Diversification and careful investment selection may help manage it.
Related Terms
