MBS risk that mortgage borrowers repay sooner than expected, changing investor cash flow.
Prepayment risk is the risk that mortgage borrowers repay loans sooner than expected, changing the cash flow received by mortgage investors.
Prepayment risk matters because homeowners can often refinance, sell, or pay extra principal before the original schedule ends. That flexibility is valuable to borrowers, but it creates uncertainty for investors who expected mortgage cash flows to last longer.
The term also matters because investor expectations about prepayment can influence mortgage pricing. Borrower choices, rate changes, and refinance waves all feed into how mortgage-backed securities are valued.
Borrowers rarely see prepayment risk named directly during application. They experience the borrower side of it when they refinance, sell, make principal curtailments, or pay off the mortgage early.
The term becomes useful when explaining why mortgage rates and rate locks are connected to a bond market that cares about how long loans are likely to remain outstanding.
| Borrower action | Investor cash-flow effect |
|---|---|
| Refinance after rates fall | Existing loan may pay off earlier than expected |
| Sell the home | Mortgage may be paid off through sale proceeds |
| Make extra principal payments | Balance falls faster than scheduled |
| Term | What it helps describe |
|---|---|
| Conditional Prepayment Rate | Annualized prepayment speed |
| Single Monthly Mortality | Monthly prepayment speed |
| PSA Prepayment Model | Benchmark convention for comparing assumed speeds |
| Average Life | Expected timing of principal return |
Mortgage rates fall and many borrowers refinance. Their old loans pay off early, so investors in the related mortgage pools receive principal back sooner than expected. That is prepayment risk.
Prepayment risk differs from Extension Risk because prepayment risk is about loans paying off too quickly for investor expectations, while extension risk is about loans staying outstanding longer than expected.
It also differs from Prepayment Penalty. Prepayment risk is an investor cash-flow risk; a prepayment penalty is a loan term that may charge the borrower for early payoff in limited situations.