Prepayment of loan

Prepayment is the early repayment of a loan by a borrower, in part or in full, often as a result of optional refinancing to take advantage of lower interest rates.

In the case of a mortgage-backed security (MBS), prepayment is perceived as a financial risk—sometimes known as "call risk"—because mortgage loans are often paid off early in order to incur lower interest payments through cheaper refinancing. The new financing may be cheaper because the borrower's credit has improved or because market interest rates have fallen; but in either of these cases, the payments that would have been made to the MBS investor would be above current market rates. Redeeming such loans early through prepayment reduces the investor's upside from credit and interest rate variability in an MBS, and in essence forces the MBS investor to reinvest the proceeds at lower interest rates. If instead the borrower's opportunities deteriorate (creditworthiness declines or market interest rates rise), then the borrower loses the incentive to refinance, since the existing mortgage interest rate cannot be reduced with a new mortgage. The fact that MBS investors are exposed to downside prepayment risk, but rarely benefit from it, means that these bonds must pay an incrementally higher interest rate than similar bonds without prepayment risk, to be attractive investments. (This is the embedded "option cost" that results in a lower option-adjusted spread.) Similar issues arise for callable bonds in the American municipal, corporate, and government agency sectors.