Prepayment risk arises when borrowers repay their loans before the scheduled maturity date, impacting the expected income of lenders and investors. This is most common when interest rates fall, prompting borrowers to refinance at lower rates and pay off existing loans early.
For example, consider a borrower with a 30-year mortgage at 6% interest. If interest rates drop to 3.5%, the borrower might refinance to save money, repaying the original loan ahead of time. While this benefits the borrower, the initial lender loses on future interest income and must now reinvest the principal at the lower current rates.
This risk affects not only banks and mortgage companies but also investors holding mortgage-backed securities (MBS) — investments backed by pools of mortgages. When borrowers prepay these mortgages, the MBS investors receive their principal back sooner than expected, reducing their income flow and potential returns. For more about MBS, see our article on mortgage-backed securities.
Borrowers may prepay loans for several reasons beyond refinancing, such as selling a home, receiving a financial windfall, or making extra payments to reduce interest over time.
Lenders and investors use strategies to manage prepayment risk, including:
- Prepayment Penalties: Fees charged when loans are repaid early, though these are less common and more regulated today. Learn more in our glossary entry on prepayment penalty.
- Higher Interest Rates: Charging slightly more on loans likely to be prepaid to offset potential losses.
- Diversification: Spreading investments across various assets to minimize impact.
- Call Protection: Features on bonds preventing early repayment during certain periods.
As a borrower, prepayment risk usually works in your favor by lowering your interest expenses. However, always review your loan agreement for any prepayment penalties to avoid unexpected fees. More tips on loan agreements and refinancing can be found in our articles on loan agreement terms and refinancing risks.
For authoritative information, see the Consumer Financial Protection Bureau’s guide on prepayment penalties.