Refinancing Risk

DEFINITION of 'Refinancing Risk'

1. The risk that an early unscheduled repayment of principal on mortgage-backed securities(MBS) will occur when the underlying mortgages are refinanced by borrowers. All MBS buyers assume some level of prepayments in their initial yield calculations, but an increase in the level of refinancing (which usually occurs as a result of falling interest rates) means that MBSs mature faster and will have to be reinvested at lower rates.

2. For a mortgage borrower, the risk that he or she will not be able to refinance an existing mortgage at a future date under favorable terms.

BREAKING DOWN 'Refinancing Risk'

1. The prepayment estimates used to price mortgage-backed securities are made based on market conventions known as "speeds". There are two primary measures of mortgage prepayment speeds: the conditional prepayment rate and the Public Securities Association standard prepayment model.

2. Typically, refinancing risk is associated with short-term mortgage products such as hybrid ARMs and payment option ARMs. Borrowers often take on unforeseen risks when they assume that they will be able to refinance out of an existing mortgage at some planned future date - usually before a payment or interest rate reset date - to avoid an increase in their monthly payments. Interest rates might rise substantially before that date, or home price depreciation could lead to a loss of equity, which might make it hard to refinance as planned.

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