What is a 'Zero Prepayment Assumption'

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.

BREAKING DOWN 'Zero Prepayment Assumption'

A zero prepayment assumption is one crucial and simple scenario of many used by analysts to construct complex financial models for valuing asset- and mortgage-backed securities (MBS). It is crucial as a baseline against which to evaluate scenarios with different rates of prepayment. Zero prepayment assumptions present a clean if unrealistic, circumstance where not a single borrower makes a payment ahead of the due date.

Prepayment is a crucial variable in the valuation of debt securities. It tends to be driven by prevailing interest rates, especially in the case of mortgage-backed securities (MBS). As interest rates climb, borrowers are likely to be content with their borrowing rates and will see no incentive to make advanced installation payments. If interest rates decline, borrowers will be motivated to refinance their debt or to take advantage of a new loan with a lower rate and will be more likely to make prepayments.

A second variable contributing to the prepayment of residential loans is turnover. Turnover is the rate at which homes change hands due to life events such as relocation or job change. Over extended periods of time, turnover tends to remain constant. During periods of stable or rising interest rates, however, analysts examine turnover to explain prepayment activity. Factors contributing to turnover include seasonality and the age of a loan.

Prepayment is a significant risk to holders of MBS for two reasons. First, early payment leads to lost cash flows later in the life of the mortgage. Second, there is a strong possibility that the borrower is prepaying to refinance at a lower rate, earning the lender lower interest payments, if any, as part of the new loan.

How Realistic is Zero Prepayment?

Zero prepayment is not a realistic scenario. It is not intended as a model for valuing mortgage-backed security during a period with zero prepayments. The zero prepayment assumption is a benchmark for comparison to the multiple scenarios brought about by complex financial models. Explicitly, by holding the hypothetical prepayment at zero, analysts can model the impacts of other variables on debt valuation. Such factors might include default, severity, or catastrophic loss.

  1. Prepayment

    Prepayment is a satisfaction of a debt or installment payment ...
  2. Constant Percent Prepayment

    Annualized estimate of mortgage loan prepayments, computed by ...
  3. Prepayment Risk

    Prepayment risk is the risk associated with the early unscheduled ...
  4. Prepayment Privilege

    A prepayment privilege extends a right to a debt holder to pay ...
  5. Contraction Risk

    Contraction risk is the risk that borrowers will increase the ...
  6. Portfolio Runoff

    A decrease in the assets of a mortgage-backed securities portfolio ...
Related Articles
  1. Investing

    Advanced Bond Concepts

    Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration.
  2. Investing

    Commercial real estate loans

    Obtaining a commercial real estate loan is quite different from borrowing for residential real estate. Here's what to expect and how to get what you need.
  3. Personal Finance

    Interest-Only Mortgages: Home Free or Homeless?

    These loans can be beneficial, but for many borrowers, they present a financial trap.
  4. Personal Finance

    Personal Loans: Consider These Alternative Lenders

    Looking for an alternative source of financing for a personal loan? Take a look at these companies.
  5. Personal Finance

    Top 10 Common Mortgage Scams To Avoid

    How do you know which companies to avoid? Look for these telltale signs.
  6. Personal Finance

    All-Time Low Mortgage Rates: Time To Refinance?

    Interest rates keep dipping lower and lower. Find out what it takes to tip the scales toward a refinance.
  7. Personal Finance

    8 Top Alternatives to Car Title Loans

    Before you sign up for a car title loan, investigate these 8 alternate strategies.
  8. Investing

    Subprime Lending: Helping Hand or Underhanded?

    These loans can spell disaster for borrowers, but that doesn't mean they should be condemned.
  1. Why do MBS (mortgage-backed securities) still exist if they created so much trouble ...

    Read several different arguments in favor of allowing the trade of mortgage-backed securities, even after the financial crisis ... Read Answer >>
  2. How are prepaid expenses recorded on an income statement?

    Understand how prepaid expenses are recorded on a company's financial statements. Learn why a prepaid expense would be considered ... Read Answer >>
Hot Definitions
  1. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  2. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  3. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  4. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  5. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  6. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
Trading Center