Prepayment Risk

What is prepayment risk?

Prepayment risk is the chance that mortgage borrowers will repay principal earlier or later than an investor expected. Mortgage payments arrive on a schedule, but borrowers can refinance, move, sell a property, or otherwise pay off a loan before its stated maturity.

Why timing matters

When interest rates fall, refinancing often becomes more attractive. Borrowers may repay higher-rate mortgages early, returning principal to the owner of the mortgage or mortgage-backed security. That money may then need to be reinvested at a lower yield.

When rates rise, refinancing often slows. Principal may return more slowly, leaving the investor holding a lower-yielding asset for longer than expected. This is commonly called extension risk. The two risks are closely connected because both come from uncertainty about the life of the mortgage cash flows.

A simple example

A mortgage REIT owns an RMBS yielding 6%. Mortgage rates fall, many homeowners refinance, and principal comes back sooner than expected. If similar new securities yield 4.5%, the company may earn less after reinvesting the returned cash.

The Fly High perspective

Fly High follows prepayment risk because it can change the company-specific earnings measure and dividend coverage. We keep the focus on the earnings result rather than building a separate mandatory prepayment score.

This article is for general education. It is not personal investment advice or a recommendation to buy or sell any security.