Changes in interest rates create problems for banks due to mismatches of fixed-rate and floating-rate instruments, as well as differences in time to maturity, rate-setting frequency, and indexes. But changes in interest rates also lead to prepayment risk.
Prepayment risk occurs when a borrower repays the principal sooner than required. Prepayment is a problem because the bank gets stuck re-lending the money at a less favorable interest rate.
Prepayments occur through:
• Curtailment (the borrower pays an additional principal amount along with their scheduled mortgage payment; this reduces the balance of the loan)
• Housing turnover (the borrower sells the property and pays off the loan)
• Refinancing (the borrower gets a new loan and pays off the first loan)
The most important factor affecting prepayment is the refinancing rate. However, prepayment is also affected by:
• Borrower characteristics (e.g., credit score)
• Geographic location
• Mortgage seasoning
• Seasonality
• The burnout effect
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