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. A prepayment is the settlement of a debt or installment payment before its official due date. It can either be made for the entire balance of a liability or for an upcoming payment that is paid in advance of the date for which the borrower is contractually obligated to pay. Examples of prepayment include rent or early loan repayments.
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).
The Basics of a Prepayment Model
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.
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.
A zero prepayment assumption describes 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.
- Prepayment models try to estimate how much a loan pool will experience prepayments in order to properly evaluate their price and risk.
- Prepayments are when loan balances are paid off early in whole or in part.
- The Public Securities Association (PSA) Prepayment Model is among the most widely used.
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 in 1985. The Public Securities Association eventually became the Bond Market Association and, in 2006, it merged with the Securities Industry Association to become the Securities Industry and Financial Markets Association (SIFMA).
The prepayment model is still referred to by its original name, but due to the subsequent name changes of the association, it is sometimes called the Bond Market Association PSA. It is also quite common for the acronym for the model to be confused with the identical acronym for former Public Securities Association as well as an acronym for the function of the model, that is, providing a prepayment speed assumption (PSA).
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.