What is a Constant Percent Prepayment
Constant percent prepayment is an annualized estimate of mortgage loan prepayments, computed by multiplying the average monthly prepayment rate by 12. This is used to determine cash flow in structured finance transactions, often referred to as the secondary mortgage market. It models the risk of unscheduled return of principal, which affects fixed income returns. Constant percent prepayment may be abbreviated as CPP. A constant prepayment, or CPP, is just one of several types of prepayment models that are used to help calculate loan estimates and returns.
BREAKING DOWN Constant Percent Prepayment
How is the constant percent prepayment calculated? Market data suggests that the average mortgage is paid off in its 12th year, which leads to assumption of 12-year-prepaid life. Using this number, a banker or loan officer can determine the single monthly mortality rate, which is the average prepayment monthly rate. To determine the constant percent prepayment the single monthly mortality rate is multiplied by 12, which provides the CPP. However, because the CPP derived from the x12 model is based on the original monthly payment, it does not account for compounded monthly interest. The Conditional Prepayment Rate or CPR, on the other hand, does account for monthly compounded interest and is therefore considered to be a more accurate number. A CPR is an average rate based on the loan principal instead of merely the payment.
The yields of the CPP are based on assumed prepayment rates. Among the most active participants in the secondary market are Fannie Mae and Freddie Mac, both of which are government-sponsored enterprises.
Advantages of the Constant Percent Prepayment
The CPP can be helpful in order to provide a consumer with an estimate of his or her prepayment rate for a loan, as well as to give the loan owner or originator a snapshot of what they can expect for their return. In accounting for the fact that the CPP does not include compounded interest, the CPP actually provides a low estimate for rate of return, because with the interest, the amount paid back will be higher than the CPP, assuming the 12-year rule still applies. The CPP is also only applicable if the mortgage is paid back in the average of 12 years. However, because the CPP doesn’t account for compounded interest, even if the mortgage is paid off in a more timely manner, the rate of return will not change as much as a CPR might.