DEFINITION of Prepayment Model
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 models are based on mathematical equations and usually involve the analysis of historical prepayment trends. Prepayment models are often used to value mortgage pools such as GNMA securities or other securitized debt products.
BREAKING DOWN 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.
Example of a Prepayment Model
One of the most notable prepayment models is the PSA Prepayment Model by the Securities Industry and Financial Markets Association. The PSA model assumes increasing prepayment rates for the first 30 months and then constant prepayment rates afterward.
The standard model, 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. 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.