What Is a Prepayment Model?

Jan 19, 2024 By Susan Kelly

In the field of lending, a model for prepayment can be used to determine the prepayment percentage in a loan portfolio, which will occur over a specific period of time in light of the possibility of fluctuations in rates. Prepayment refers to paying an obligation or a portion of debt before the deadline. It may be done to pay the entire amount due or an installment to come up; however, in all cases, the payment is paid before the contractually binding date for the borrower. Prepayment models are built on mathematical equations and typically require the analysis of historical trends in prepayment to determine what might occur shortly.

How a Prepayment Model Works

Prepayment models start with a zero-prepayment assumption, a base scenario used for financial modeling. In this scenario, a borrower or borrower does not make late debt payments. This model provides a point of reference for more complex prepayment models and permits analysts to study the effect of other variables on the valuation without the risk of prepayment. A basic model for prepayment is a constant percent of prepayment (CPP), which is an estimate for the annualization of prepayments on mortgage loans calculated by multiplying the median per month prepayment by 12.

This model calculates the cash flow in structured finance transactions, often called the "secondary mortgage market. It is a model for the risk of principal return that is not scheduled that affects return on investment for fixed income. A constant prepayment is only one of many prepayment models employed to calculate loan returns and loan amounts estimates.

While prepayment models and prepayments can be used to deal with different types of liability or debt, they are generally used for mortgages and mortgage-backed securities. When interest rates increase, the models that prepay include fewer prepayments since most people aren't keen on swapping their mortgage with one with a greater interest rate and a monthly payment. Suppose interest rates drop in the opposite direction. In that case, the reverse impact is taken into account since more people are likely to refinance their loans to eliminate their current mortgage to get one that has a lower rate and a monthly payment. Prepayment is more prevalent in the mortgage sector than other loans, like consumer or car loans. This is because the amount of principal on this loan is huge, the term is lengthy, and the law has stipulated that there is no penalty for early payment. Therefore, this type of loan makes the prepayment via refinancing or the borrower's cash worth the effort.

Refinancing loans to refinance more often results in the mortgages currently in the pools being paid before the expected maturation date. Prepayments reduce current mortgage payments paid into the mortgage pools, which reduces the flow of money paid out to investors.

Types of Prepayment Models

The lenders employ a variety of prepayment models to estimate and assess the risk of prepayment. In the end, there are numerous types of prepayment models and rates that you can choose. Discover the three most popular prepayment options below.

Single Monthly Mortality

It is also known as the SMM amount is the sum of the principal mortgage loan balance, which is paid off over a month. To determine the SMM, the method is to divide the total prepayments in the month by your principal amount at the start, with fewer principal payments scheduled for the month.

Conditional Prepayment Rate

The model is like the model with a single month's mortality; however, it reveals the percentage of prepayment as an annual compounded rate. The loan's outstanding principal is paid during the year by the SMM. It is the simple mean for the SMM for the year.

PSA Prepayment Model

It is the most well-known prepayment model, and it is the one from which most other models get their bases. The model specifies an amount of prepayment per month during the term of the loan or mortgage, which is calculated annually. It is based on prepayments increasing gradually in the initial 30 months of the loan. After that, prepayment expectations increase till the expiration date of the loan. To make it more specific, the PSA starts with a CPR of 0.2 percent in the initial month following the origination. It then increases by 0.2 percent per month up to the end of the month. When the 30-month month is over, it is assumed that the PSA assumes the 6 percent CPR amount for the balance.

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