Question

Please name and describe in details the THREE sources of prepayment in the mortgage market.

Answer 1

Prepayment is the settlement of a debt or part of a debt before its official due date. It can either be made for the entire balance or for an upcoming installment, but in any case, the payment is made in advance of the borrower's contractually obligated date.

Prepayments and prepayment models are typically used with mortgages and mortgage-backed securities.

If interest rates fall, prepayment models factor in higher prepayments as more people will refinance their loans in an effort to close out their existing mortgage in favor of one with a lower interest rate and monthly payment.

Increased refinancing of loans results in the existing mortgages within the pools being paid off before the anticipated maturity date of the loan. These prepayments ultimately reduce the ongoing mortgage payments being made into the mortgage pools, reducing the stream of payments made out to investors.

Sources of prepayment:

1. Loan Refinancing - In case of a fall in interest rates, borrowers try to refinance their loans at lower interest rates. This leads to prepayment of existing mortgages (the prepayment option gets deep in the money).

2. FHA mortgage - In case a borrower becomes eligible for FHA mortgage at lower interest rates, he/she might replace a commercial bank's mortgage with FHA mortgage.

3. Sale of property - A mortgage could prepay even when rates are high because the mortgagor sells the property or the property is destroyed (the mortgagor may be forced to exercise the option when it is out of the money)