What are MBS Prepayments?
Mortgage-Backed Securities are long term contracts with payments of both interest and principal. As the contracts are long term, there is an option of paying the amount back before the entire contract term. Generally, the borrower pays the monthly payment amount, and the interest and principal follow the amortisation schedule. But there is also a possibility of paying an amount in excess of the required payment or even paying off the loan entirely. The prepayment option may benefit the borrower in the absence of prepayment penalties.
Example of MBS Prepayments?
There are three ways through which mortgage prepayments can be made:
- Increasing the frequency or amount of payments,
- Refinancing the outstanding balance,
- Repaying the outstanding balance because the property is sold.
Why are MBS Prepayments important?
Prepayments are more likely to occur when market interest rates fall and borrowers wish to refinance their mortgages at a new and lower rate. Hence, risk managers must understand the prepayment risk.