What are Mortgage Backed Securities Prepayment

Mortgage-backed securities (MBS) are one of the largest and most important parts of the bond market — and the single feature that makes them distinctive is prepayment. Because the homeowners behind an MBS can pay off their mortgages early, the cash flows an MBS investor receives are uncertain in a way ordinary bonds aren't. This guide explains what mortgage-backed securities are, what prepayment means, why it matters, and how it's measured — in clear, plain language. It complements our guide to tranches and is relevant to anyone studying fixed income or structured finance.

What are mortgage-backed securities?

A mortgage-backed security is a bond-like investment backed by a pool of mortgages. A lender originates many home loans, pools them together, and issues securities whose cash flows come from the homeowners' monthly mortgage payments — both interest and principal. Investors who buy the MBS effectively receive a share of those payments. The simplest form is a pass-through security, where payments from the pool are passed straight through to investors, minus a small servicing fee. MBS let lenders free up capital to make new loans, and give investors access to the returns from mortgage lending without originating the loans themselves directly.

What is prepayment?

Prepayment is when borrowers repay their mortgage principal earlier than scheduled. This happens for several everyday reasons: homeowners refinance when interest rates fall, move house and pay off the old loan, sell the property, or simply make extra payments. Because the loans in the pool can be prepaid, the MBS investor doesn't know exactly when they'll get their principal back. This uncertainty is the defining characteristic of mortgage-backed securities — and the source of their main risk. Unlike a normal bond, where principal is repaid on a known maturity date, an MBS returns principal gradually and unpredictably over time.

Why prepayment matters: prepayment and extension risk

Prepayment creates two linked risks for investors:

• Prepayment (contraction) risk — when interest rates fall, many borrowers refinance, so principal comes back faster than expected. The investor must then reinvest that money at the new, lower rates — exactly when they'd prefer not to. This is why MBS are said to have negative convexity: they don't gain as much as ordinary bonds when rates fall.
• Extension risk — when interest rates rise, prepayments slow down (fewer people refinance or move), so the investor's principal is returned more slowly, leaving money locked in a now-below-market-rate security for longer.

So whichever way rates move, prepayment behaviour tends to work against the MBS investor — a key reason MBS typically offer extra yield to compensate.

How prepayment is measured

Because prepayment is so important, the market has developed standard ways to measure it. The conditional prepayment rate (CPR) expresses prepayments as an annualised percentage of the remaining pool — a 6% CPR means roughly 6% of the outstanding balance is expected to prepay over a year. The monthly equivalent is the single monthly mortality (SMM) rate. The widely-used PSA model (from the Public Securities Association) describes a standard ramp in which prepayment speeds rise over the first 30 months of a pool's life and then level off, with "100% PSA" as the benchmark speed. These measures let investors model the likely timing of cash flows.

How prepayment affects value

Prepayment assumptions feed directly into how an MBS is priced and analysed. They determine the security's expected average life (how long, on average, the principal stays outstanding) and its yield. Faster prepayments shorten the average life; slower ones lengthen it. Because the timing of cash flows is uncertain, valuing MBS is more complex than valuing a plain bond and often relies on prepayment models and option-adjusted analysis. Tranching (as in collateralised mortgage obligations) is partly a way to redistribute prepayment risk among investors with different preferences.

Frequently asked questions

What are mortgage-backed securities?

Bond-like investments backed by a pool of mortgages, where investors receive cash flows from homeowners' monthly mortgage payments of interest and principal.

What is prepayment?

When borrowers repay mortgage principal earlier than scheduled — through refinancing, moving, selling or extra payments — making the timing of an MBS investor's cash flows uncertain.

What are prepayment and extension risk?

Prepayment risk: when rates fall, faster refinancing returns principal early, forcing reinvestment at lower rates. Extension risk: when rates rise, prepayments slow, locking money in for longer.

How is prepayment measured?

By the conditional prepayment rate (CPR), the single monthly mortality (SMM) rate, and the PSA model, which describes a standard ramp of prepayment speeds with 100% PSA as the benchmark.

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