Question:

When is mortgage prepayment risk higher to investors and lenders, and why?

Answer:

The mortgage prepayment risk rises along with property appreciation, as borrowers tend to sell the appreciated property, or take a cash-out refinance - both resulting in early mortgage loan prepayments. It is the expected but unearned interest on principal that reduces the expected future income of mortgage loans and mortgage backed securities.

Investors sometimes do take higher mortgage loan prepayment risks.

There is certain risk that goes with mortgage-backed securities (MBSs). Fixed income securities, as MBSs, may not have the expected yield of return/maturity. In that case, investors who paid for premium MBSs take the risk of lower yield than estimated when those securities were purchased.

Investors buying mortgage backed securities with higher than market rates take on additional risk that the underlying mortgage loans will be repaid. Home appreciation, falling market rates and subprime mortgage terms combined indicate particularly high risk that mortgage loans will be prepaid.

There is high mortgage loan prepayment risk to mortgage lenders, too.

Beside investors buying mortgage-backed securities, primary mortgage lenders (banks, unions, Mortgage Brokerage Businesses (MBB), etc.) also take high home loan prepayment risks with certain loans. Actually, with many of them.

Many borrowers are no longer patiently waiting for the interest rate to drop 2%. Rather, they are extensively shopping on their own for better mortgage rates and terms and are not afraid to refinance with another lender, if they feel unsatisfied with their own mortgage.

Consumers do in fact agree to pay certain interest cost (IC) upon inception of the loan. When selling or refinancing with another lender, they are actually reducing the expected future income of the lender, so this is why a prepayment penalty is provided.

However, lenders have in a way become more flexible and imaginative in designing newer mortgage products to appeal to a larger type of audience - no matter if conservative or more investment-savvy - to offset the risk of relying on only one type of customers.

Also, lenders impose prepayment penalty clauses to protect themselves from loan prepayment. Those can be particularly costly, especially in the case of loans extended to consumers with marred credit history, high LTV and reduced documentation.

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