Prepayment of loan
Prepayment is the early repayment of a loan by a borrower, in part (commonly known as a
In the case of a
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]
References
- ^ a b c 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.
- ISBN 978-0-471-38587-5, p.24