Prepayment of loan
In the case of a mortgage-backed security (MBS), prepayment is perceived as a risk—sometimes known as "call risk"—because mortgage loans are often paid off early in order to incur lower total interest payments through cheaper refinancing. The new financing may be cheaper because the borrower's credit rating 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 upside of 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 rate cannot be reduced with a new mortgage. The fact that MBS-holders 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 option-adjusted spread.) Similar issues arise for callable bonds in the municipal, corporate, and government agency sectors.
As another way to compensate for prepayment risk (which is a reinvestment risk), 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.
Readers should be aware that some auto maker loans contain hidden prepayment penalties. Where a choice is offered between a below market rate loan and a rebate, "Zero percent financing, or $1,000 rebate" for example, hidden penalties arise. That $1,000 rebate given up if the "zero" rate loan is taken amounts to a $1,000 increase in the vehicle's price, in lieu of interest. If the $1,000 had stayed interest, charges would cease to accrue upon repayment. But since the $1,000 is classified as principle (in order to produce the deceptive "zero percent" loan), it must be paid in full regardless of when it is paid. It is hoped that the recent transfer of administrative responsibility of the Truth-in-Lending Act of 1968 to the Consumer Finance Protection Bureau will result in reform that will eliminate the misleading loan terms, including the hidden prepayment.
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.
Homeowner prepayment decisions are impacted by a number of factors 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), or multiples of PSA.
- Lemke, Lins and Picard, Mortgage-Backed Securities, Chapter 4 (Thomson West, 2013 ed.).
- "Simply Mortgages — When Do I Pay a Prepayment Penalty?". Retrieved 2010-04-10.
- Hayre, Lakhbir, Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities (Wiley: 2001) ISBN 978-0-471-38587-5, p.24
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