Question:

Why is mortgage prepayment speed useful and what are the standards of its measurement?

Answer:

Mortgage prepayment speed is useful in evaluating the risk of a mortgage backed security (MBS). Because homeowners try to refinance their mortgages when interest rates drop, it turns a mortgage loan that was earning a higher interest into a less profitable one.

This means that for every mortgage approved there is a prepayment risk for the mortgage originator. The prepayment risk is measured using mortgage prepayment speed. The higher the prepayment speed for mortgage loans, the greater will be the risk for mortgage originators. This risk is a prime factor in setting the price of a MBS in the secondary mortgage market.

Standards of Measurement:

The mortgage industry has developed different standards for measuring prepayment speeds. We will discuss three of them which apply to a pool of fixed-rate mortgages collateralizing a mortgage-backed security.

Single Monthly Mortality:

SMM, for any given month, is equal to the unscheduled prepayments during a month divided by the scheduled balance for the end of the month. It is usually expressed as a percentage.

SMM = [(Beginning pool balance - ending pool balance) - Scheduled payment] / (Beginning Pool Balance - Scheduled Principal)

Conditional Prepayment Rate:

CPR is simply SMM over a period of one year instead of one month. Specifically, CPR indicates, for any given year, the fraction of mortgages principal that had not prepaid at the beginning of the year that does prepay during the year.

CPR = 1 - (1-SMM)12
*A good approximation is CPR = 12 x SMM

A very basic way to compute the potential for a group of mortgages to prepay over their lifetime is to project a constant CPR. Even though this is not very realistic but it forms a good starting point for more detailed analysis.

Constant CPR projections facilitate comparisons between different pools of mortgages.  One big shortcoming of such projections is that they ignore the fact that mortgage prepayment rates are very low in the early years of a mortgage and increase as time goes by.

Mortgage rates hit their lowest since 1955. Ask the home loan experts we recommend Quicken Loans how to take advantage of them.
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