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Prepayment is the early repayment of a loan by a borrower, in part or in full, often as a result of optional
refinancing Refinancing is the replacement of an existing debt obligation with another debt obligation under a different term and interest rate. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic ...
to take advantage of lower
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s.Lemke, Lins and Picard, ''Mortgage-Backed Securities'', Chapter 4 (Thomson West, 2013 ed.). In the case of a
mortgage-backed security A mortgage-backed security (MBS) is a type of asset-backed security (an 'instrument') which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals (a government agency or investment ba ...
(MBS), prepayment is perceived as a
financial risk Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financia ...
—sometimes known as "call risk"—because
mortgage loan A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pu ...
s are often paid off early in order to incur lower interest payments through cheaper
refinancing Refinancing is the replacement of an existing debt obligation with another debt obligation under a different term and interest rate. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic ...
. The new financing may be cheaper because the borrower's credit has improved or because market interest rates have fallen; but in either of these cases, the payments that ''would have been made'' to the MBS investor would be above current market rates. Redeeming such loans early through prepayment reduces the investor's upside from credit and interest rate variability in an MBS, and in essence forces the MBS investor to reinvest the proceeds at lower interest rates. If instead the borrower's opportunities deteriorate (creditworthiness declines or market interest rates rise), then the borrower loses the incentive to refinance, since the existing mortgage interest rate cannot be reduced with a new mortgage. The fact that MBS investors are exposed to downside prepayment risk, but rarely benefit from it, means that these bonds must pay an incrementally ''higher'' interest rate than similar bonds without prepayment risk, to be attractive investments. (This is the embedded "option cost" that results in a lower
option-adjusted spread Option-adjusted spread (OAS) is the yield spread which has to be added to a benchmark yield curve to discount a security's payments to match its market price, using a dynamic pricing model that accounts for embedded options. OAS is hence model-de ...
.) Similar issues arise for
callable bond A callable bond (also called redeemable bond) is a type of bond (debt security) that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity. In other words, on the cal ...
s in the American
municipal A municipality is usually a single administrative division having corporate status and powers of self-government or jurisdiction as granted by national and regional laws to which it is subordinate. The term ''municipality'' may also mean the g ...
,
corporate A corporation is an organization—usually a group of people or a company—authorized by the state to act as a single entity (a legal entity recognized by private and public law "born out of statute"; a legal person in legal context) and re ...
, and
government agency A government or state agency, sometimes an appointed commission, is a permanent or semi-permanent organization in the machinery of government that is responsible for the oversight and administration of specific functions, such as an administratio ...
sectors. As another way to compensate for prepayment risk (which is a
reinvestment risk Reinvestment risk is a form of financial risk. It is primarily associated with fixed income securities (including bonds), in the form of early redemption risk and coupon reinvestment risk. Early redemption One form of reinvestment risk is th ...
), a prepayment penalty clause is often included in the loan contract. "Soft" prepayment terms can allow prepayment without penalty if the home is sold. "Hard" prepayment terms do not allow any exceptions without penalty. Bond issuers can mitigate some prepayment risk by issuing what are called "super sinker" bonds. Super sinkers are usually home-financing bonds that repay bondholders their principal quickly if homeowners prepay their mortgages. In other words, mortgage prepayments are used to retire a specified maturity. Super sinkers are likely to be paid off in a relatively short time. As a result, the bondholders may receive higher long-term yields after only a short period. Individual borrowers who expect to prepay their loans early should generally favor a combination of lower principal balance and higher interest rate (which stops accruing after prepayment), rather than a below-market interest rate and higher principal balance (which much be paid in full, regardless of prepayment). In general, only borrowers who expect to keep their loans for many years should opt for below-market interest rates by paying mortgage origination points or forgoing automobile rebates. Homeowner prepayment decisions are impacted by a number of variables and are notoriously hard to predict, adding another layer of uncertainty to investing in MBS markets. Prepayment speeds can be expressed in SMM (Single Monthly Mortality), CPR (Conditional Prepayment Rate, which is the annually compounded SMM), or PSA (percentage of the Public Securities Association prepayment model). For mortgages at least 30 months old, 100% PSA = 6.0% CPR = 0.51% SMM, equivalent to the full prepayment of 6% of a pool's remaining mortgages each year.Hayre, Lakhbir, ''Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities'' (Wiley: 2001) , p.24


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