Quick Answer
Prepayment risk is the risk that a borrower repays principal earlier than expected, most relevant for mortgage-backed securities and callable bonds. When interest rates fall, homeowners refinance, returning principal early, and investors must reinvest at lower rates. Extension risk is the opposite: rising rates slow prepayments and extend the investment's life.
Prepayment risk is a specialized form of reinvestment risk that primarily affects mortgage-backed securities. Understanding it requires knowing how borrower behavior changes with interest rates.
What Is Prepayment Risk?
- Prepayment risk is the risk that a borrower repays principal earlier than expected
- Most relevant for mortgage-backed securities (MBS) and callable bonds
- When interest rates fall, homeowners refinance their mortgages at lower rates, paying off the old mortgage early
- MBS investors receive their principal back sooner than expected and must reinvest at the new, lower prevailing rates
How It Works
Interest rates fall → Homeowners refinance → Mortgages paid off early → MBS investors get principal back → Must reinvest at lower rates
- The faster prepayments happen, the shorter the effective life of the MBS
- Investors lose the higher-yielding cash flows they were counting on
Extension Risk: The Opposite Problem
- Extension risk is the opposite of prepayment risk
- When interest rates rise, homeowners stop refinancing (why trade a low-rate mortgage for a high-rate one?)
- Prepayments slow dramatically, extending the life of the MBS beyond expectations
- Investors are stuck holding a below-market-rate investment for longer than anticipated
| Scenario | What Happens | Risk Name | Impact on MBS Investors |
|---|---|---|---|
| Rates fall | Homeowners refinance; prepayments speed up | Prepayment risk | Principal returned early; reinvest at lower rates |
| Rates rise | Homeowners hold mortgages; prepayments slow | Extension risk | Stuck in lower-yielding investment longer |
Exam Tip: Gotchas
- Prepayment risk and extension risk are two sides of the same coin. Rates fall = prepayment risk (money comes back too fast). Rates rise = extension risk (money comes back too slowly).
- Neither outcome is favorable for MBS investors. Prepayment forces reinvestment at lower rates; extension locks you into a below-market yield.
What Should You Check on Exam Day?
- Can you explain why mortgage-backed securities carry prepayment risk?
- Do you know why falling interest rates trigger prepayment risk?
- Can you explain the difference between prepayment risk and extension risk?
- Do you know why rising interest rates cause extension risk instead?
- Can you explain why neither prepayment risk nor extension risk favors MBS investors?