What is prepayment risk? How does prepayment risk affect the cash flow stream on a fully...

Question:

What is prepayment risk?

How does prepayment risk affect the cash flow stream on a fully amortized mortgage loan?

What are the two primary factors that cause early payment?

Mortgages Amortization:

In finance, a mortgage is a loan which the borrower uses for the purpose of purchasing a house. The lender expects to receive payments periodically at specified time intervals which are allocated to pay the accrued interest and partly settle the outstanding loan balance.The payments made are calculated based on the principle of time value of money given the loan amount, interest rate and loan term.Just as any security the mortgage which is considered as an asset to the lender has some degree of risk associated with it.

Answer and Explanation:

Question 1

Prepayment risk in relation to mortgages is uncertainty surrounding the timing of payments made by the borrower. It is the risk that the borrower may payoff the unpaid loan balance earlier than the expected time. The prepayment risk may arise when the rates are decreasing and this serves as an incentive to the borrower to repay the outstanding amount before the agreed loan term.

Question 2

For a fully amortised mortgage loan the investor or lender expects to receive cash flows in form of interest payments and principal payments over the defined time period. Prepayment risk affects the interest the lender would have earned if the loan was held as per the agreed term.Therefore the investor will have to accept a lower than expected return.

Question 3

1. Change in the prevailing interest rates - If the interest rates decrease, the borrower has an incentive to refinance the existing loan with a loan charging a lower interest rate.

2. Change in the household turnover - the prepayment may be influenced by change in employment status of the mortgagee


Learn more about this topic:

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Buying a House: Mortgage Types & Loan Length

from Finance 102: Personal Finance

Chapter 7 / Lesson 4
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