Prepayment Risk

AAA

DEFINITION of 'Prepayment Risk'

The risk associated with the early unscheduled return of principal on a fixed-income security. Some fixed-income securities, such as mortgage-backed securities, have embedded call options which may be exercised by the issuer, or in the case of a mortgage-backed security, the borrower.

The yield-to-maturity of such securities cannot be known for certain at the time of purchase since the cash flows are not known. When principal is returned early, future interest payments will not be paid on that part of the principal. If the bond was purchased at a premium (a price greater than 100) the bond's yield will be less than what was estimated at the time of purchase.

INVESTOPEDIA EXPLAINS 'Prepayment Risk'

For a bond with an embedded call option, the higher a bond's interest rate relative to current interest rates, the higher the prepayment risk.

For example, on a mortgage-backed security, the higher the interest rate relative to current interest rates, the higher the probability that the underlying mortgages will be refinanced. Investors who pay a premium for a callable bond with a high interest rate take on prepayment risk. In addition to being highly correlated with falling interest rates, mortgage prepayments are highly correlated with rising home values, as rising home values provide incentive for borrowers to trade up in homes or use cash-out refinances, both leading to mortgage prepayments.

RELATED TERMS
  1. Constant Percent Prepayment

    Annualized estimate of mortgage loan prepayments, computed by ...
  2. Prepayment

    The satisfaction of a debt or installment payment before its ...
  3. Fannie Mae - Federal National Mortgage ...

    A government-sponsored enterprise (GSE) that was created in 1938 ...
  4. Contraction Risk

    The risk faced by the holder of a fixed income security when ...
  5. Extension Risk

    The risk of a security's expected maturity lengthening in duration ...
  6. Mortgage-Backed Security (MBS)

    A type of asset-backed security that is secured by a mortgage ...
RELATED FAQS
  1. What is a Ginnie Mae security?

    A Ginnie Mae, or Government National Mortgage Association security, functions similarly to the process of lending someone ...
Related Articles
  1. Bonds & Fixed Income

    Profit From Mortgage Debt With MBS

    Mortgage-backed securities can offer monthly income, a fixed interest rate and even government backing.
  2. Bonds & Fixed Income

    Asset Allocation In A Bond Portfolio

    An investor's fixed-income portfolio can easily beat the average bond fund. Learn how and why!
  3. Bonds & Fixed Income

    The Risks Of Mortgage-Backed Securities

    Find out how weighted average life guards against prepayment risk.
  4. Options & Futures

    Give Yourself More Options With Real Estate Options

    Real estate options have many benefits, including a smaller initial capital requirement.
  5. Credit & Loans

    How To Become a Mortgage-Backed Securities Analyst

    Specializing in structured or derivative credit products like mortgage-backed securities requires education and prior experience in the mortgage field.
  6. Investing

    3 Major Risks For Annaly’s Investors

    Thanks to its double-digit dividend yield, Annaly Capital Management has long been a favorite among income-seeking investors.
  7. Investing

    Ready To Invest In Financial Leverage Funds?

    Whenever you invest in a leveraged financial fund or are thinking about doing so, it's important to know the risks that could weigh on its returns.
  8. Options & Futures

    The Fancy Way To Diversify Your Portfolio: Precious Metal Options

    A guide with strategies on how to invest or trade in precious metals by using options.
  9. Options & Futures

    When And How To Take Profits On Options

    Here are the different criteria to ensure maximum profit taking while trading options.
  10. Taxes

    Before You Visit Your Tax Preparer: Do This

    The earlier you start preparing your tax records and documents, the more likely you are to have a smooth tax return experience – and all the tax benefits you're due.

You May Also Like

Hot Definitions
  1. Prepaid Expense

    A type of asset that arises on a balance sheet as a result of business making payments for goods and services to be received ...
  2. Gordon Growth Model

    A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. ...
  3. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
  4. Law Of Supply

    A microeconomic law stating that, all other factors being equal, as the price of a good or service increases, the quantity ...
  5. Investment Grade

    A rating that indicates that a municipal or corporate bond has a relatively low risk of default. Bond rating firms, such ...
  6. Fringe Benefits

    A collection of various benefits provided by an employer, which are exempt from taxation as long as certain conditions are ...
Trading Center