Prepayment risk is the amount of potential that exists for an investor or lender to not receive the projected return from the transaction. Risk of this type is associated with any type of lending situation where interest is assessed on the balance, or where investors purchase bonds in anticipation of recovering the face value plus some type of interest from the venture. Lenders and investors routinely consider the level of this type of risk before initiating any type financial transaction.
Lenders usually are aware of consumer trends as they apply to the type of loans offered. Along with common trends, lenders may also look at the credit history of applicants to determine if they are a good risk in general and if they have a reputation for paying debts on time. Between the general averages related to the industry and the specific payment history of the loan applicant, it is possible to develop a reasonable idea of the prepayment risk involved with issuing the loan.
Mortgage prepayment risk is determined in much the same way as the risk associated with any other type of loan. While few mortgage companies would fault a client for paying off the balance of the mortgage early, the ideal situation is for the debtor to pay off the balance according to the schedule defined in the terms and conditions. This ensures that the mortgage holder earns the best return on the mortgage loan.
The potential for prepayment risk tends to be higher at times when interest rates for mortgages and other loans begin to fall. When rates decrease, debtors may choose to apply for a second loan with a lower interest, use the proceeds to pay off the previous loan, and earn a break on interest payments due to the early payoff. As a result the original lender earns less from the loan than originally anticipated.
Prepayments risk is also a factor that investors in bond issues should consider. In order to earn the best return on a bond, the investor hopes that the bond remains in effect all the way to maturity. If the bond is called early, the investor does recoup his or her original investment, but generally will earn a smaller return. For this reason, it is a good idea to consider the nature of the bond and determine if there is a good chance the bond will be called before maturity.
Prepayment risks are different from other types of financial risk, in that lenders and investors do not have to be concerned about losing their original investment. However, a transaction that carries a high possibility of being settled early will mean less return is earned. While a prepayment risk unscheduled return is usually not enough to deter a mortgage lender from approving a loan, bond investors may think twice before purchasing a bond issue that is highly likely to yield a lesser return due to early repayment.