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Mortgage Prepayment Risk for Banks
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Changes in interest rates create problems for banks due to mismatches of fixed-rate and floating-rate instruments, as well as differences in time to maturity, rate-setting frequency, and indexes. But changes in interest rates also lead to prepayment risk.
Prepayment risk occurs when a borrower repays the principal sooner than required. Prepayment is a problem because the bank gets stuck re-lending the money at a less favorable interest rate.
Prepayments occur through:
• Curtailment (the borrower pays an additional principal amount along with their scheduled mortgage payment; this reduces the balance of the loan)
• Housing turnover (the borrower sells the property and pays off the loan)
• Refinancing (the borrower gets a new loan and pays off the first loan)
The most important factor affecting prepayment is the refinancing rate. However, prepayment is also affected by:
• Borrower characteristics (e.g., credit score)
• Geographic location
• Mortgage seasoning
• Seasonality
• The burnout effect
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Prepayment risk occurs when a borrower repays the principal sooner than required. Prepayment is a problem because the bank gets stuck re-lending the money at a less favorable interest rate.
Prepayments occur through:
• Curtailment (the borrower pays an additional principal amount along with their scheduled mortgage payment; this reduces the balance of the loan)
• Housing turnover (the borrower sells the property and pays off the loan)
• Refinancing (the borrower gets a new loan and pays off the first loan)
The most important factor affecting prepayment is the refinancing rate. However, prepayment is also affected by:
• Borrower characteristics (e.g., credit score)
• Geographic location
• Mortgage seasoning
• Seasonality
• The burnout effect
—
Edspira is the creation of Michael McLaughlin, an award-winning professor who went from teenage homelessness to a PhD. Edspira’s mission is to make a high-quality business education freely available to the world.
—
SUBSCRIBE FOR A FREE 53-PAGE GUIDE TO THE FINANCIAL STATEMENTS, PLUS:
• A 23-PAGE GUIDE TO MANAGERIAL ACCOUNTING
• A 44-PAGE GUIDE TO U.S. TAXATION
• A 75-PAGE GUIDE TO FINANCIAL STATEMENT ANALYSIS
• MANY MORE FREE PDF GUIDES AND SPREADSHEETS
—
SUPPORT EDSPIRA ON PATREON
—
GET CERTIFIED IN FINANCIAL STATEMENT ANALYSIS, IFRS 16, AND ASSET-LIABILITY MANAGEMENT
—
LISTEN TO THE SCHEME PODCAST
—
GET TAX TIPS ON TIKTOK
—
ACCESS INDEX OF VIDEOS
—
CONNECT WITH EDSPIRA
—
CONNECT WITH MICHAEL
—
ABOUT EDSPIRA AND ITS CREATOR
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