prepay

What It Is

Prepayment occurs when a borrower pays off a loan earlier than expected.

How It Works

For example, let's say that John Doe borrows $300,000 to buy a house in Phoenix. The loan is a 30-year mortgage at 5% interest. John lives in the house for five years and makes his payments on time every month. However, in year six, he gets a job offer in Philadelphia and decides to move there. Accordingly, he sells his house. At the closing, the buyer gives John $500,000 for his house. John uses $250,000 to pay off the remaining balance on the loan instead of making 25 more years of payments. John has prepaid the loan.

Why It Matters

When a borrower prepays a loan, the borrower saves a lot of interest. But that means the lender also misses out on all that interest. Accordingly, prepayment can sometimes come with a penalty, and this is disclosed in the loan documents.

People who invest in pass-through securities are also frequently concerned about prepayment. That's because those securities that receive payments from an intermediary that collects payments from a pool of assets. The most famous of these is mortgage-backed securities (MBS), which represent an interest in a pool of mortgage loans.

When people move, as we’ve seen, they sell their houses, payoff their mortgages with the proceeds, and buy new houses with new mortgages. When interest rates fall, many homeowners refinance their mortgages, meaning they obtain new, lower-rate mortgages and pay off their higher-rate mortgages with the proceeds. This means the lenders and the MBS investors miss out on interest income due to prepayment.

Source: Investing Answers