Prepayment Risk

Written By
Paul Tracy
Updated July 21, 2021

What is Prepayment Risk?

Prepayment risk is the risk that a borrower will pay off a loan earlier than expected.

How Does Prepayment Risk Work?

For example, let's say that John Doe borrows $300,000 to buy a house in Phoenix. The loan is a 30-year mortgage at 5% interest. The lender, Bank XYZ, expects to make, say, $100,000 in interest over the life of the loan.

John lives in the house for five years and makes his payments on time every month. However, in year six, he gets a job offer in Philadelphia and decides to move there. Accordingly, he sells his house. At the closing, the buyer gives John $500,000 for his house. John uses $250,000 to pay off the remaining balance on the loan instead of making 25 more years of payments. John has prepaid the loan, and Company XYZ has "lost out" on collecting, say, $70,000 of interest that it would have earned over the remaining 25 years of the loan.

Why Does Prepayment Risk Matter?

When a borrower prepays a loan, the borrower saves a lot of interest. But that means the lender also misses out on all that interest. Accordingly, prepayment can sometimes come with a penalty, and this is disclosed in the loan documents.

However, you may have noticed that most mortgage amortization schedules break mortgage payments out into principal and interest and that those first several payments are nearly all interest. Accordingly, this mitigates some of the lender's prepayment risk, because the longer John is in his house and the more payments he makes, the more of that $100,000 in interest he's giving the lender. In other words, he's paying most of the interest up-front. If John sells the house after, say, 20 years, when the lender has collected virtually all of its $100,000 in interest, the lender is subject to much less prepayment risk. That is, it doesn't forgo much interest if he sells the house and pays off the loan early.

People who invest in pass-through securities are also frequently concerned about prepayment risk. That's because those securities that receive payments from an intermediary that collects payments from a pool of assets. The most famous of these is mortgage-backed securities (MBS), which represent an interest in a pool of mortgage loans.

When people move, as we’ve seen, they sell their houses, payoff their mortgages with the proceeds, and buy new houses with new mortgages. When interest rates fall, many homeowners refinance their mortgages, meaning they obtain new, lower-rate mortgages and pay off their higher-rate mortgages with the proceeds. This means the lenders and the MBS investors miss out on interest income due to prepayment.

Activate your free account to unlock our most valuable savings and money-making tips
  • 100% FREE
  • Exclusive money-making tips before we post them to the live site
  • Weekly insights and analysis from our financial experts
  • Free Report - 25 Ways to Save Hundreds on Your Monthly Expenses
  • Free Report - Eliminate Credit Card Debt with these 10 Simple Tricks
Ask an Expert
All of our content is verified for accuracy by Paul Tracy and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about Prepayment Risk.
Be the first to ask a question

If you have a question about Prepayment Risk, then please ask Paul.

Ask a question

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

If you have a question about Prepayment Risk, then please ask Paul.

Ask a question Read more from Paul
Paul Tracy - profile
Ask an Expert about Prepayment Risk

By submitting this form you agree with our Privacy Policy

Don't Know a Financial Term?
Search our library of 4,000+ terms