Prepayment Risk
Prepayment risk is the chance that borrowers repay a loan early, usually when interest rates fall. Lenders and holders of mortgage-backed securities then get their money back just when it can only be reinvested at lower rates.
Getting repaid early sounds like good news, but not for an investor counting on years of high interest. When rates fall, homeowners refinance, and mortgage investors lose their best-paying loans. This is prepayment risk, and it shapes the behaviour of mortgage-backed securities and callable bonds. This entry explains how it works, why it hurts and how investors are compensated for it.
- Category
- Bonds and Interest Rates
- Reading time
- 3 min
- Also called
- Prepayment, Early repayment risk
- Updated
Prepayment risk in plain words
Prepayment risk is the risk that all or part of a loan's principal is paid back early by the borrower.1
When rates fall, homeowners have an incentive to refinance, so the original lender loses the higher interest payments it expected.1
Mortgage-backed security investors are effectively lending to homebuyers and receive their interest and principal, so they bear this risk too.2
How prepayment risk plays out, step by step
Investor buys high-yield loans
E.g. mortgages at 7%.
Rates fall
New mortgages cost 5%.
Borrowers refinance
Old loans are repaid early.
Investor gets cash back
Sooner than expected.
Reinvests at lower rates
See Reinvestment Risk.
Price upside is capped
See Convexity.
Worked examples
Example 1 — Lost interest
−$4,000/yrA lender holds a $200,000 mortgage at 7%; rates fall to 5% and the borrower refinances.
| Old annual interest | $14,000 |
| New annual interest on reinvested cash | $10,000 |
| Income lost | $4,000 a year |
When the borrower refinances, the lender gives up the remaining higher-rate interest payments.1
Example 2 — Capped price gain
Upside cappedRates fall 1 point. A 10-year Treasury rises about 8% in price; a mortgage pool rises only about 3%.
| Treasury | +8% |
| MBS | +3% |
Expected refinancing shortens the MBS and caps its price gains, a pattern called negative convexity. See Convexity.
Example 3 — Rates rise instead
Extension riskRates rise 2 points; refinancing slows to a trickle.
| Effect | Investor stuck longer at below-market yield |
The mirror image, extension risk, means MBS lengthen just when investors would prefer shorter bonds. See Duration.
Prepayment risk vs extension risk
| Aspect | Prepayment risk | Extension risk |
|---|---|---|
| Triggered by | Falling rates | Rising rates |
| Borrower behaviour | Refinances early | Keeps old loan |
| Effect on investor | Cash back at low rates | Locked in at low yield |
| Effect on duration | Shortens | Lengthens |
Where prepayment risk matters
Mortgage-backed securities
Callable bonds
Issuers call when rates fall. See Callable and Putable Bonds.
Bank loan books
Planning interest income.
Hedging
MBS investors use swaptions. See Swaption.
Advantages and disadvantages
Advantages
- Investors are paid extra yield for bearing it.
- Prepayment speeds can be modelled.
- Structured products can split the risk.
Disadvantages
- Income falls just when rates drop.
- Price upside is capped.
- Hard to forecast borrower behaviour.
Going deeper
Read as far as you need. Each level builds on the one before it.
Why early repayment is a risk
Beginner
Repaying early sounds positive, but it is a risk to lenders because they lose expected interest at a higher rate.1
Pass-throughs and CMOs
Intermediate
The two basic MBS types are pass-through securities and collateralised mortgage obligations, which can slice prepayment risk into tranches.2
Prepayment models
Advanced
Analysts model prepayment speeds from rates, home prices and borrower behaviour; those assumptions drive MBS valuations and yield spreads.
Common mistakes
Treating MBS like Treasuries
Cash flows are uncertain.
Ignoring refinancing incentives
Rate drops speed repayment.
Chasing the yield premium
It pays for real risk.
Forgetting extension risk
Rising rates hurt too.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Prepayment risk is the risk of early loan repayment.
- It rises when interest rates fall.
- Investors must reinvest at lower rates.
- It caps MBS price gains (negative convexity).
- Extension risk is the opposite problem.
Frequently asked questions
Why is prepayment a risk if I get my money back?
Do prepayment penalties help?
Which investments carry prepayment risk?
Further learning
- Mortgage- and Asset-Backed Securities
Where the risk lives.
- Convexity
Why MBS prices behave oddly.
- Agency Bonds
Agency-backed mortgage debt.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Corporate Finance Institute. Prepayment Risk (opens in a new tab) Checked .
- Corporate Finance Institute. Mortgage-Backed Security (MBS) (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.