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Prepayment Risk

Step-by-Step Guide to Understanding Prepayment Risk

Last Updated September 10, 2023

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Prepayment Risk

What is the Definition of Prepayment Risk?

Prepayment risk is a type of financial risk that pertains to lending agreements between lenders and borrowers regarding interest-bearing securities, such as bonds and mortgage-backed securities (MBS).

The importance of the prepayment risk stems from the fact that the cash flows expected to be received by the lender, like a bank or institutional investor, become altered by a borrower’s decision to pay back a loan ahead of the originally agreed upon schedule.

Therefore, prepayment risk can be best described as the burden of uncertainty faced by lenders from the risk of premature payments on debt.

In effect, the risk of prepayment must be closely analyzed in the underwriting process of lenders.

The perceived risk can be mitigated via the lending terms to reduce the uncertainty of cash flows – i.e. interest expense (or interest income from the perspective of the lender) and the return on the original principal in full – as well as the risk of needing to re-deploy the earlier than expected receipt of the original loan principal under different market conditions.

The methods to mitigate the prepayment risk is at the discretion of the lender and the specific security at hand, as each is arranged using different terms that offer a different risk-reward profile, so it is up to the lender to determine the most appropriate strategies to balance based on their unique investment strategy and risk appetite.

What is the Importance of Prepayment Risk?

Prepayment risk is one of the factors that ultimately determine the interest rate attached to a particular debt security.

  • Borrower Incentive → If interest rates were to fall, borrowers are more likely to refinance their outstanding debt obligations to take advantage of the lower rates, i.e. paying off the old loan to take on a new loan at more favorable rates.
  • Lender Risk → For the lenders that provide the debt financing, their investment is paid off early, resulting in a different yield than expected, with the need to reinvest the returned principal at the current interest rates.

To compensate for the incremental prepayment risk, lenders often demand a higher yield on securities with an outsized prepayment risk – termed the “prepayment risk premium” – wherein if the prepayment risk is perceived to be high, a greater prepayment risk premium is priced into the securities.

If the market consensus among participants predicts that a significant number of borrowers are likely to repay their loans earlier in anticipation of declining interest rates, the market interest rates at present can also be affected indirectly, i.e. a “self-fulfilling prophecy”.

The complexities surrounding the prepayment risk, interest rates, and the behaviors of market participants in response to changing economic conditions and outlook on interest rate changes must therefore be closely monitored in the underwriting process.

What Causes Prepayment Risk?

There can be numerous reasons that a borrower might decide to pay back a loan in advance, however, the most common reason tends to be declining interest rates in the economy.

Since a financing environment with falling interest rates is more favorable to borrowers at the expense of lenders, a borrower could weigh the trade-off associated with refinancing at “cheaper” rates, which is a decision predicated on if refinancing is more economically beneficial in the long run.

  • Reinvestment Risk → In such cases, the lender would receive the original principal back earlier than expected, which can be disadvantageous because of the reduced probability of being able to reinvest the returned funds at a comparable return.
  • Reduction in Sources of Income → Prepayment risk also impacts the total cumulative amount of interest collected by lenders on an outstanding loan. If a loan were to be paid off earlier than expected, the principal of the loan is reduced – a determinant of the interest owed by the borrower in a given period – since interest is a function of the outstanding principal balance.
  • Less Time for Interest Accrual → In the case of debt securities structured with paid in kind (PIK) interest, there is less time for the interest to accrue (i.e. “interest on interest”), which can decrease the total interest income the lender initially expected to receive on the date of original issuance.

What are the Methods to Reduce Prepayment Risk?

The prepayment risk cannot be removed entirely for the most part, yet can still be mitigated through various methods.

  • Prepayment Penalties → The most common method utilized by lenders to discourage prepayment is the imposition of prepayment penalties, or fees to compensate the lender for the additional risk undertaken. The prepayment fees are “triggered” and incurred by borrowers upon deciding to pay off the loan before its maturity date. Based on the terms of the lending agreement, prepayment penalties can either be a fixed amount or can be calculated as a percentage of the remaining loan balance.
  • Call Protection and Lockout Periods → The call protection feature, or “call premium”, can be attached to debt securities, most often bonds, to prohibit the issuer from prematurely redeeming the security. The restriction placed on the borrower to pay off the debt earlier mitigates the prepayment risk since for at least the period in which the call protection is in effect – or the “lockout period” – the cash flows earned by the lender are more predictable. In the lockout period, the borrower is unable to pay off the debt ahead of schedule. For riskier securities such as bonds, the call protection period tends to be briefer, whereas for long-term debt securities like mortgages, the lockout period is much longer in comparison.
  • Non-Callable Feature → If a bond is categorized as “non-callable”, the security cannot be redeemed before its maturity date. Like short-term lockout periods, the non-callable feature is more common for riskier debt securities with shorter maturities. On the other hand, a callable bond is one where the borrower possesses the right to repay the debt securities prior to maturity, assuming the call protection period has passed.
  • Yield Maintenance Penalty Provision→ The yield maintenance prepayment penalty is not as prevalent as the call protection clause. Here, the lender is essentially guaranteed to receive the originally anticipated yield, i.e. the hypothetical return if the borrower were to have met all scheduled interest payments and principal paydown at maturity. The yield maintenance premium is designed to make lenders whole if the borrower were to prepay, but most borrowers tend to push back more strongly against the inclusion of such features.
  • Portfolio Diversification → For lenders and institutional investors, portfolio diversification is a method to mitigate the risk of prepayment by allocating the risk across numerous different securities, each with different terms, risk-return profiles and maturities, which reduces the concentration of the prepayment risk on a single financing agreement.
  • Hedging Strategies → Lenders and institutional investors can also rely on more specialized financing instruments, such as interest rate swaps and derivatives, to further hedge against the risk of prepayment.

How Prepayment Risk Impacts Mortgage Backed Securities (MBS)

A real-life example reflecting the prepayment risk concept are mortgage-backed securities (MBS), where a homeowner might decide to refinance their mortgages and pay the loan off earlier than expected.

Mortgage-backed securities (MBS) are a complex type of asset-backed security where the financing is secured by a claim on a mortgage, such as a residential property loan, or collection of mortgages (a “pool”).

So, why might a homeowner decide to repay part of a mortgage sooner than planned?

Under the specific context of mortgage loans, the effect of prepayment risk on these securities is as follows.

  • Earlier Receipt of Principal → If a homeowner decides to prepay their mortgage, either partially or in full, the principal of the mortgage-backed security is returned earlier than expected. The lender must reinvest the capital in a lower interest rate environment, in which the likely outcome becomes lower returns from less favorable terms.
  • Uncertainty of Income → Mortgage-backed securities (MBS) are backed by the steady inflow of cash payments from a pool of mortgages. If a significant number of these secured loans were to be prepaid, the cash flows and yield earned by the investor become overall less predictable.
  • Change in Duration → The risk of prepayment can affect the duration of a mortgage-backed security (MBS). Duration measures the sensitivity of the price of debt obligation to changes in interest rates. If the number of prepayments rise from a decline in interest rates, the duration of an MBS decreases since cash flows are being received earlier. From that, mortgage backed securities become less sensitive to declines in interest rates. On the other hand, if interest rates were to rise and the number of prepayments declines, the duration on such securities would extend, and the MBS becomes more sensitive to increases in the market interest rate. The aforementioned inverse relationship is referred to as “negative convexity”.
  • Reduced Lender Yield → The interest portion of a mortgage payment is the periodic interest received by the lender of the mortgage loan. If a mortgage is prepaid, that stream of income would subsequently end sooner than expected. Even if the principal is reinvested, it might be at a lower interest rate, resulting in a lower yield.

Prepayment risk is frequently considered among the more critical risk factors to lenders that determines the appropriate pricing of debt securities and the terms attached.

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