Prepayment Risk

Many loans, especially mortgages, allow borrowers to repay early. When interest rates fall, borrowers often refinance at lower rates, repaying their existing loans.

For investors in mortgage-backed securities and other loan-based investments, this can be a disadvantage. They receive their money back sooner than expected, just when interest rates are low, so they can only reinvest at lower yields. They also lose the higher interest payments they expected.

For example, an investor holding mortgage-backed securities paying 6% might find that, after rates fall to 4%, many homeowners refinance, and the investor receives principal back that can only be reinvested at around 4%.

The opposite risk, extension risk, occurs when rates rise and prepayments slow, so investors are stuck with lower-yielding assets for longer. Because of these risks, mortgage-backed securities behave differently from ordinary bonds, and their prices rise less when rates fall. Prepayment models attempt to forecast borrower behaviour.