A prepayment rate, also known as the constant prepayment rate (CPR), is a metric used in lending and investing to measure how quickly loans in a pool are being repaid ahead of their scheduled repayment timeline. Specifically, the prepayment rate measures the percentage or proportion of the principal of a pool of loans that gets repaid ahead of schedule each period.
For example, a prepayment rate of 10% for a pool of mortgages would mean 10% of the total remaining mortgage principal gets repaid extra by borrowers each year instead of being paid down based on the standard amortization schedule.
How Prepayment Rate is Calculated
The prepayment rate is calculated by dividing the total principal that was prepaid over a specific time period by the total principal amount outstanding at the beginning of the time period across a pool of loans. This can be represented by the following formula:
Prepayment Rate = (Total Principal Prepaid over Time Period X) / (Total Principal Outstanding at Beginning of Time Period X)
Most often, the prepayment rate is calculated on a monthly or yearly basis. So for an annual rate, the time period X would be one year. Most pools have a prepayment rate calculated every month and an annualized average rate.
Here’s a simplified example of how it works:
- A portfolio of mortgages has $10 million total principal outstanding at the beginning of the year
- By the end of the year, an additional $500,000 has been prepaid ahead of schedule
- Prepayment Rate = $500,000 prepaid / $10 million principal at beginning of year = 5%
So for this pool of mortgages, there was a 5% prepayment rate over the course of the year. That gives a sense for how quickly borrowers paid down extra principal during that period.
Pros of Prepayments for Borrowers
Prepaying loans ahead of schedule has some major benefits for borrowers:
Pay Loans Faster
By making extra payments, borrowers end up paying off the full balance faster and shorten the life of the loan. This saves money on total interest paid over the long run.
Flexibility in Financial Planning
Having variable cash flows makes personal finance planning difficult. Prepayments give borrowers flexibility to pay down debt faster during times when they have extra disposable income. This creates more reliability in planning future cash flows.
Lower Lifetime Interest Costs
As mentioned before, prepaying cuts down the total interest paid to lenders over the course of a loan. Even if closing costs and penalties apply, most borrowers still come out ahead with the interest savings.
Potentially Avoid Fees or Penalties
Some loans allow borrowers to pay down principal penalty-free to a certain point. This allows saving on interest without incurring extra fees. Borrowers can take advantage of these provisions through strategic prepayments.
Build Home Equity Faster
For secured loans like mortgages and home equity loans or lines, paying principal faster builds the equity in the home at a quicker rate. This gives homeowners more financial flexibility in the future.
Cons of Prepayments for Lenders
While prepayments benefit borrowers in several ways, they introduce some headaches and risks for lenders:
Cash Flow Planning Challenges
When a large share of borrowers prepays loans early, it throws off the expected timing of payments and cash flows. This makes it harder for lenders to plan budgets and deploy capital efficiently.
Reinvestment Risk
Upon receiving prepayments, lenders suddenly have a chunk of capital on hand they need to redeploy. However, current interest rates when the capital is received may be lower than portfolio rates. This can lead to assets getting reinvested at lower yields.
Operational Costs and Overhead
Handling and processing prepayments requires effort from staff and systems. If prepayment volume is high enough, it can meaningfully increase overhead expenses. This may slow improvements in efficiency ratios.
Loss of Interest Income
For lenders focused on interest income, like banks, prepayments equate to a loss of revenue versus the scheduled amounts. This directly reduces bottom line profitability.
Importance for Debt Investors
Prepayment behaviors and assumptions are critical for fixed income debt investors for a few key reasons:
Impacts Yields and Returns
As discussed above, prepayments change the timing of expected cash flows. Higher prepayments lead to faster paydowns of principal. Since debt investors pay a premium for the right to these cash flows, speeding them up impacts yields and investment returns.
Interest Rate Exposure
Prepayments tend to spike when interest rate fall, as borrowers refinance existing debt. Therefore, prepayment activity introduces interest rate risk into otherwise fixed rate bonds. Debt investors must factor this risk into decisions.
Reinvestment Opportunities
Heavy volumes of prepayments must get reinvested by investors into new securities. The rate environment at the time determines whether this reinvestment is beneficial, neutral, or negative. Investors gauge asset selection and portfolio construction in light of expected prepayment reinvestment.
In short, understanding expectations for prepayment rates allows debt investors to properly price assets, model returns, and structure optimal portfolios to achieve mandates. Specialized investors even look to capitalize on particular prepayment trends across various credit markets.
Prepayment Penalties
Some lenders include prepayment penalties in loan contracts to discourage early paydowns and mitigate prepayment risk. These penalties come in a variety of forms:
Term Based
Term based penalties only apply prepayments made within a certain window, such as the first 1-5 years of a mortgage. This still allows penalties while limiting their scope.
Fixed Fee
A set dollar amount fee charged whenever certain prepayment thresholds are exceeded within a period. This is simpler to model for consumers.
Interest Rate Based
With this approach, a fee gets charged on prepaid principal equivalent to a certain month’s worth of interest, such as 1-6 months. The fee amount thus varies by size.
Declining Balance
Under this structure, the prepayment fee is a percentage that declines over time on an accelerated schedule. This attempts to mirror natural burnout behavior over the life of a pool.
Originators choose prepayment fee structures that best reduce risks for themselves and investors depending on particular portfolio attributes. The details are usually negotiable on a borrower level based on credit strength.