prepayment n : payment in advance
- A payment in advance.
Prepayment is early repayment of a loan by a borrower.
In the case of a mortgage-backed security (MBS), prepayment is perceived as a risk, because mortgage debts are often paid off early in order to incur lower total interest payments through cheaper refinancing. The new financing may be cheaper because the borrower's credit rating has improved or because interest rates are lower, but in either case, the payments that would have been made to the MBS investor would be above market rates. Redeeming such loans early through prepayment reduces the upside of credit & interest rate variance in an MBS. The downside of these variances (interest rates rises or creditworthiness declines) does not normally induce a refinancing (since the fixed mortgage payments are now at below-market rates). The fact that MBS-holders are exposed to downside prepayment risk, but rarely benefit from it, means that these bonds must pay a slightly higher interest rate than similar bonds without prepayment risk, to be attractive investments. (This is the Option Adjusted Spread.)
To compensate for the prepayment risk (which is a reinvestment risk), prepayment penalty clause is often included into the loan contract.
There are often soft prepayment terms versus hard prepayment terms. Soft prepayment terms can allow you prepayment without penalty under the terms of selling the home. Hard prepayment does not allow any exceptions without penalty.
prepayment in German: Vorfälligkeitsentschädigung