A prepayment rate, also known as the constant prepayment rate (CPR), is a metric used in lending to measure 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 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. 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 loans, 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 save on interest, end up paying off the full balance faster, and shorten the life of the loan.
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 (generally for mortgages or low interest rate secured assets). This allows saving on interest without incurring extra fees.
Build Home Equity Faster
For secured loans like mortgages and home equity loans or lines, paying the principal faster builds the equity in the home at a quicker rate.
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 prepay loans early, it throws off the expected timing of payments and cash flows. It also reduces the total interest earned by the lender. The added advantage though is that also reduces default risk.
Reinvestment Risk
Debt investors have to efficiently manage capital deployment. They can’t have too much or too little capital on hand. High and uncertain prepayments make capital planning difficult. If the lender doesn’t redeploy capital quickly, their overall yield could be low.
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.
Products with Prepayments
Below are the most common products with their prepayment rates. The highest prepayment rates are with secured products like mortgages and the lowest with unsecured products like personal loans.
| Lending Product | Prepayment Rate | Description |
|---|---|---|
| Mortgages (Refinanced) | High | Homeowners frequently refinance to take advantage of lower interest rates, leading to prepayments. |
| Auto Loans | High | Borrowers often pay off auto loans early to avoid interest costs or sell the vehicle. |
| Personal Loans | Moderate to High | Consumers may prepay to reduce debt faster or consolidate loans. |
| Credit Cards (Balance Transfers) | Moderate | Prepayment occurs when balances are transferred to cards with lower interest rates or paid off entirely. |
| Business Loans (Term Loans) | Moderate to High | Businesses often prepay term loans to reduce liabilities or improve cash flow. |
| Student Loans (Private) | Moderate | Prepayments may occur as borrowers seek to reduce high-interest debt faster. |
| Home Equity Loans | Moderate | Homeowners may prepay to avoid interest or refinance their home equity loan. |
| SBA Loans (Certain Types) | Moderate | Small businesses may prepay to avoid longer-term interest costs, especially for 7(a) loans. |
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.