Prepayment of loan

Last updated June 11, 2023

Prepayment is the early repayment of a loan by a borrower, in part (commonly known as a curtailment) or in full, often as a result of optional refinancing to take advantage of lower interest rates.^[1]

In the case of a mortgage-backed security (MBS), prepayment is perceived as a financial risk—sometimes known as "call risk"—because mortgage loans are often paid off early in order to incur lower interest payments through cheaper refinancing. 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.^[1] 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.) Similar issues arise for callable bonds in the American 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.^[2] "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.^[1] 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.^[3]

Related Research Articles

In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to provide cash flow to the creditor. The timing and the amount of cash flow provided varies, depending on the economic value that is emphasized upon, thus giving rise to different types of bonds. The interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods. Thus, a bond is a form of loan or IOU. Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure.

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 factors such as inherent risk, projected risk, political stability of a nation, currency stability, banking regulations, borrower's credit worthiness, and credit rating of a nation. In many industrialized nations, common forms of refinancing include primary residence mortgages and car loans.

An interest-only loan is a loan in which the borrower pays only the interest for some or all of the term, with the principal balance unchanged during the interest-only period. At the end of the interest-only term the borrower must renegotiate another interest-only mortgage, pay the principal, or, if previously agreed, convert the loan to a principal-and-interest payment (amortizing) loan at the borrower's option.

<span class="mw-page-title-main">Collateralized mortgage obligation</span> Type of debt security backed by mortgages

A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor needs.

A mortgage-backed security (MBS) is a type of asset-backed security which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy. Bonds securitizing mortgages are usually treated as a separate class, termed residential; another class is commercial, depending on whether the underlying asset is mortgages owned by borrowers or assets for commercial purposes ranging from office space to multi-dwelling buildings.

<span class="mw-page-title-main">Asset-backed security</span> Security with value derived from a commodity or asset

An asset-backed security (ABS) is a security whose income payments, and hence value, are derived from and collateralized by a specified pool of underlying assets.

Fixed-income arbitrage is a group of market-neutral-investment strategies that are designed to take advantage of differences in interest rates between varying fixed-income securities or contracts. Arbitrage in terms of investment strategy, involves buying securities on one market for immediate resale on another market in order to profit from a price discrepancy.

Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial and multifamily mortgages rather than residential real estate. CMBS tend to be more complex and volatile than residential mortgage-backed securities due to the unique nature of the underlying property assets.

Reinvestment risk is a form of financial risk. It is primarily associated with fixed income securities, in the form of early redemption risk and coupon reinvestment risk.

A PIK, or payment in kind, is a type of high-risk loan or bond that allows borrowers to pay interest with additional debt, rather than cash. That makes it an expensive, high-risk financing instrument since the size of the debt may increase quickly, leaving lenders with big losses if the borrower is unable to pay back the loan.

In the United States, a mortgage note is a promissory note secured by a specified mortgage loan.

<span class="mw-page-title-main">Mortgage loan</span> Loan secured using real estate

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 purpose while putting a lien on the property being mortgaged. The loan is "secured" on the borrower's property through a process known as mortgage origination. This means that a legal mechanism is put into place which allows the lender to take possession and sell the secured property to pay off the loan in the event the borrower defaults on the loan or otherwise fails to abide by its terms. The word mortgage is derived from a Law French term used in Britain in the Middle Ages meaning "death pledge" and refers to the pledge ending (dying) when either the obligation is fulfilled or the property is taken through foreclosure. A mortgage can also be described as "a borrower giving consideration in the form of a collateral for a benefit (loan)".

A Jumbo mortgage is classified in the United States as a residential mortgage or other home-equity secured loan in an amount greater than $650,000, although lenders differ on just what constitutes a super jumbo mortgage subject to their own internal investment criteria. Super Jumbo mortgages are made available to borrowers whose loan requirements exceed the guidelines commonly referred to as Jumbo loan limits, which apply to mortgage loan amounts in excess of the FNMA / FHLMC conforming loan limits of 417,000. Unlike Jumbo loan limits, the super jumbo mortgage category is not directly defined, controlled, or regulated by any of these aforementioned agencies. Instead, mortgage lenders internally and independently define their own parameters and criteria for what defines a Super Jumbo mortgage. The minimum loan amount for some lenders to classify a loan as Super Jumbo ranges from $500,000 to $1,500,000, with maximum super jumbo loan amounts generally running into the $10,000,000 to $20,000,000 range.

Bonds securitizing mortgages are usually treated as a separate class, termed residential mortgage-backed security (RMBS). In that sense, making reference to the general package of financial agreements that typically represents cash yields that are paid to investors and that are supported by cash payments received from homeowners who pay interest and principal according to terms agreed to with their lenders; it is a funding instrument created by the "originator" or "sponsor" of the mortgage loan; without cross-collateralizing individual loans and mortgages, it is a funding instrument that pools the cash flow received from individuals and pays these cash receipts out with waterfall priorities that enable investors to become comfortable with the certainty of receipt of cash at any point in time.

CRE Finance Council is a trade organization for the commercial real estate finance markets. CRE Finance focuses on six Forums, market constituencies that encompass the commercial mortgage industry. These Forums include Investment-Grade Bondholders, Issuers, Multifamily Lenders, Securities and Loan Investors, Portfolio Lenders and Servicers. CRE Finance Council represents more than 300 member companies.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

A renewable energy derivative is based on a new method of securitization, which is a structured finance process that pools and repackages cash-flow-producing financial assets into securities which are then sold to investors. The term "securitization" is derived from the fact that securities are used to obtain funds from investors.

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-dependent. This concept can be applied to a mortgage-backed security (MBS), or another bond with embedded options, or any other interest rate derivative or option. More loosely, the OAS of a security can be interpreted as its "expected outperformance" versus the benchmarks, if the cash flows and the yield curve behave consistently with the valuation model.

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

The mortgage industry of the United States is a major financial sector. The federal government created several programs, or government sponsored entities, to foster mortgage lending, construction and encourage home ownership. These programs include the Government National Mortgage Association, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation.

References

1 2 3 Lemke, Lins and Picard, Mortgage-Backed Securities, Chapter 4 (Thomson West, 2013 ed.).
↑ "Simply Mortgages — When Do I Pay a Prepayment Penalty?". Archived from the original on 2010-05-04. 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

This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.

[ReferenceA-1] 1 2 3 Lemke, Lins and Picard, Mortgage-Backed Securities, Chapter 4 (Thomson West, 2013 ed.).

[Simply_Mortgages-2] "Simply Mortgages — When Do I Pay a Prepayment Penalty?". Archived from the original on 2010-05-04. Retrieved 2010-04-10.

[3] Hayre, Lakhbir, Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities (Wiley: 2001) ISBN 978-0-471-38587-5, p.24

[1]

[2]

[3]