Prepayment is the early payment of a loan by a borrower either in part or full. This happens when there is a decline in market interest rates after the loan is originated. Prepayment risks are those risks that are associated with the premature payment of principal amount (portion or full) on fixed income security. This risk occurs as debtors do not have to pay the interest amount on that part of the principal which is prematurely paid by them. This deprives the lender of future interest benefits thus creating a risk to the lender. For a bondholder, prepayment risk refers to the possibility that the issuer will redeem the callable bonds prior to scheduled maturity. Prepayment risk is high for callable bonds and maturity-based securities (MBS).
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How prepayment risk works?
The working of prepayment risk is explained below in the form of examples:
Considering a loan with a face value of $5,000 and a 10% interest rate on the face value of the loan, the borrower is to make annual interest payments over a period of three years. As such, the lender would be receiving $6,500 over the life of the loan. The payment schedule of the loan is summarized below:
Presuming that the borrower has the option to repay the face value by the end of three years. In this scenario, the borrower can theoretically repay the face value of $5,000 at the end of Year 1 and end up not having to pay interest in Years 2 and 3 (due to the face value being repaid at the end of Year 1). In doing so, the lender would only end up receiving $500 in profit on the loan.
The amount of interest lost for two years is known as prepayment risk. In this case, the borrower faces a risk of $1000 because of premature payment.
XYZ Bank extended a Housing Loan to Alex for $100000 @ LIBOR +2% for 20 years. After 2 years, the rates have fallen, resulting in the same loan available to Alex from ABC Bank @LIBOR +1%. To save the Interest payment due to the reduction in Interest rate, Alex closes his Loan account by making a prepayment to XYZ Bank, which has crystallized into a Prepayment Risk for XYZ Bank.
- The decrease in Interest rates resulting in Contraction Risk where Mortgage-backed Securities will have shorter maturity than original maturity due to early closure of my borrowers resulting in the account of decline in Interest Rates.
- Increase in Interest Rate resulting in Extension Risk where prepayments will be lower than expected as Interest rate rise and borrowers continue to stay rather than making an early payment, which will lead to longer maturity than original maturity (assumptions related to prepayment will be higher than actual prepayments) on account of increase in Interest Rates.
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- Fixed instruments with prepayment risk are priced at the historical prepayment rate and when the actual prepayment rate is lower than the historical, it helps in better returns for the investor holding the same.
- Cash flows and maturity of instruments backed by MBS due to Prepayment Risk are difficult to evaluate and assess.
- It makes future interest payments uncertain.
Prepayment penalties are specified in a clause in mortgage contracts stating penalty will be assessed if the borrower significantly pays down or pays off the mortgage prematurely usually within the first five years of commitment of loans. It is sometimes based on the percentage of the remaining mortgage balance or a certain number of months’ worth of interest. In order to compensate for the prepayment risk, prepayment penalties are written under difficult economic climate and circumstances where the incentive for a borrower to refinance a subprime mortgage is high. A significant aspect of the Prepayment Risk is that it is influenced not only by the interest rate changes but also by the path taken by interest to achieve it.
Author: Urvi Surti
About the Author: Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).