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. Fannie Mae - Federal National Mortgage ...

    A government-sponsored enterprise (GSE) that was created in 1938 ...
  3. Prepayment

    The satisfaction of a debt or installment payment before its ...
  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 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. Retirement

    What is a Ginnie Mae security?

    A Ginnie Mae, or Government National Mortgage Association security, functions similarly to the process of lending someone money to purchase a house or business. Ginnie Mae buys home mortgages ...
  5. Options & Futures

    Options -- Accessing Stakes In Apple At Less Cost

    Finding Apple stock costly to trade? Here are multiple ways to trade it through low-cost Apple options.
  6. Investing Basics

    The Strange New World Of The Bitcoin Exchange Futures Market

    We explain the basics of the Bitcoin exchange and futures market.
  7. Options & Futures

    These Are The Top Brokerage Firms For Options Trading

    Trading options? Here is the list of the best brokerage firms for options trading, with features, functionality, and brokerage rates.
  8. Credit & Loans

    What are the pros and cons of owning an equity REIT versus a mortgage REIT?

    Learn about investing in equity, mortgage and hybrid REITs. Explore the different strategies REITs employ to generate income and create dividends.
  9. Options & Futures

    What is a volatility smile?

    Discover what options traders mean when they refer to a "volatility smile," and learn why a volatility smile's existence perplexes many investors and analysts.
  10. Credit & Loans

    What is the debt ratio for an FHA loan?

    Borrowing through the Federal Housing Administration requires individuals to provide proof of income as well as information relating to total outstanding debt.

You May Also Like

Hot Definitions
  1. Commercial Paper

    An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories ...
  2. Federal Funds Rate

    The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution ...
  3. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
  4. Break-Even Analysis

    An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even ...
  5. Key Performance Indicators - KPI

    A set of quantifiable measures that a company or industry uses to gauge or compare performance in terms of meeting their ...
  6. Bank Guarantee

    A guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other words, if the debtor ...
Trading Center