Reference no: EM132630304

Prepayment risk refers to the uncertainty that a borrower might repay earlier that specified in the loan documents. Most consumer mortgage loans (home mortgages) allow borrowers to prepay their loans in part or in full at any time before maturity. When might a borrower be likely to prepay a loan? There are many reasons (sale of the house when the loan has a due on sale clause, increased income levels, divorce, death, etc.), but we are most concerned with prepayment that is induced by changes in future mortgage interest rates. Suppose a borrower obtained a mortgage loan 5 years ago at 7% interest. Further suppose that today's mortgage rate is 4%. It would make good sense for the borrower to get a Version 8/13/204 new loan at the now lower rate and use the proceeds of that loan to prepay the old loan, thus reducing the cost of borrowing money going forward. When prepayment occurs in this situation, lenders who want to continue originating mortgage loans must now lend that money to another borrower at the now-prevailing interest rate of 4%. On the other hand, if the situation were reversed and the rate on the old loan is 4% and the now-prevailing rate is 7%, it is unlikely that the borrower will prepay the old "cheap money" loan. If you have studied option theory in a finance course, borrowers hold a put option and lenders face uncertainty about when/if borrowers may choose to exercise that option. (Lenders typically do not have a call option on mortgage loans.) As discussed here, prepayment risk can by considered part of interest rate risk just like inflation can be thought of as part of interest rate risk. (It is important to note here that investment property mortgage loans (in contrast to home loans to consumers) typically do not allow the borrower to prepay or, if prepayment is allowed, the borrower must pay a prepayment penalty to "make the lender whole.")

Why does the potential for prepayment of a loan lead to increased risk for lenders? (Answer using text above)