Prepayment Model

What Is a Prepayment Model?

In lending, a prepayment model is used to estimate the level of prepayments on a loan portfolio that will occur in a set period of time, given possible changes in interest rates. Prepayment is the settlement of a debt or part of a debt before its official due date. It can either be made for the entire balance or for an upcoming installment, but in any case, the payment is made in advance of the borrower's contractually obligated date.

Prepayment models are based on mathematical equations and usually involve the analysis of historical prepayment trends to predict what will happen in the future. Prepayment models are often used to value mortgage pools such as GNMA securities or other securitized debt products, including mortgage-backed securities (MBS).

Key Takeaways

• A prepayment model estimates the level of early payoffs on a loan or group of loans in a set period of time given possible changes in interest rates.
• While prepayments and prepayment models can be applied to any sort of debt or liability, they are often used with mortgages and mortgage-backed securities.
• The Public Securities Association (PSA) Prepayment Model, developed in 1985, is among the most widely used models.

How a Prepayment Model Works

Prepayment models begin with a zero prepayment assumption, a baseline scenario used in financial modeling. In this model, a borrower or borrowers make no early debt payments. It provides a point of comparison for more complex prepayment models and allows an analyst to examine the effects of other variables on valuation in the absence of prepayment risk.

One basic prepayment model is constant percent prepayment (CPP), which 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. A constant prepayment is just one of several types of prepayment models that are used to help calculate loan estimates and returns.

While prepayments and prepayment models can be applied to sort of debt or liability, they are typically used with mortgages and mortgage-backed securities. As interest rates rise, prepayment models factor in fewer prepayments because people are generally not interested in exchanging their current mortgage for one with a higher interest rate and monthly payment. If interest rates fall, the opposite effect is accounted for, as more people will refinance their loans in an effort to close out their existing mortgage in favor of one with a lower interest rate and monthly payment. The prepayment phenomenon is more pronounced in the mortgage space than in other loans such as car loans or consumer loans is because the principal of this loan is large, the tenure is long and the law made it that there is no prepayment penalties. Thus, the profile of this loan makes prepayment through refinancing or borrower's own money worth the effort.

Increased refinancing of loans results in the existing mortgages within the pools being paid off before the anticipated maturity date of the loan. These prepayments ultimately reduce the ongoing mortgage payments being made into the mortgage pools, reducing the stream of payments made out to investors.

The acronym PSA refers not only to the former Public Securities Association model but also to the function of the model—that is, providing a prepayment speed assumption.

Real World Example of a Prepayment Model

One of the most notable prepayment models is the Public Securities Association (PSA) Prepayment Model formulated by the Securities Industry and Financial Markets Association (SIFMA) in 1985. (The Public Securities Association was the forerunner of SIFMA. The prepayment model is still referred to by the organization's original name. The model also is sometimes called the Bond Market Association PSA, in reference to another association that merged with SIFMA in 2006.)

The PSA model assumes increasing prepayment rates for the first 30 months and then constant prepayment rates afterward. The standard model, which is also referred to as 100% PSA or 100 PSA, assumes that prepayment rates will increase by 0.2% for the first 30 months until they peak at 6% in month 30.

Notably, 150% PSA would assume 0.3% (1.5 x 0.2%) increases to a peak of 9%, and 200% PSA would assume 0.4% (2 x 0.2%) increases to a peak of a 12% prepayment rate.