In finance, a prepayment model estimates the total principal paid down on a loan portfolio over a certain period while accounting for the effect of interest rate changes. Prepayment is the early settlement of a debt or partial settlement of an obligation. A prepayment may be made in full or in anticipation of a future installment payment, regardless of when the borrower is due to make their legally required payment

A prepayment model is used in finance to forecast the aggregate amount of principal paid down on a loan portfolio over a specific period, considering the impact of interest rate fluctuations. "prepayment" refers to paying off a debt or a portion of an obligation before the due date.

Payment is paid before the borrower's contractually required date and might be for the total debt or a forthcoming installment. Mathematical equations provide the basis of prepayment models, which are then used to examine patterns of past prepayments to make forecasts about the future.

Using a Prepayment Model

From a starting point, financial models often assume no prepayments will ever be made. In this scenario, the borrower or borrowers do not repay the loan early. It allows an analyst to assess the effects of other variables on valuation without the confounding influence of prepayment risk, and it serves as a benchmark for more complicated prepayment models.

The constant percent prepayment (CPP) model is a simple method for estimating the total amount of interest saved over a mortgage loan's life by multiplying the average monthly prepayment rate by 12. This is the standard method for calculating cash flows in secondary mortgage market structured finance deals.

It simulates a scenario in which the principle is returned early, simulating a risk relevant to fixed-income returns. Loan estimates and returns may be calculated using many prepayment models, one of which is a continuous prepayment.

Varieties of Prepayment Schemes

A wide range of prepayment models are utilized by financial institutions in order to ascertain the degree of risk that is posed by prepayment. Due of this, there is now a diverse selection of prepayment schemes and options available for consumers to pick from. After that, we will discuss the three prepayment options that are utilized the most frequently in today's society.

Single Monthly Mortality (SMM)

For determining the amount of the monthly principle payment that is required to be made on a mortgage loan, the SMM rate is what is utilized. To get the SMM for a particular month, divide the entire amount of prepayments by the amount of the initial principal balance that has not yet been paid off, minus the total amount of any principle payments that are planned to be paid during that month.

Prepayment Rate: Conditional or Constant

The prepayment percentage in this model is calculated using a compounded yearly rate, which is the sole distinction between it and the single monthly mortality model. According to the SMM, the amount that is reimbursed after one year is the outstanding principle of the loan. It is the simple moving average of the SMM for the past 12 months.

Public Securities Association Prepayment Model

Most other prepayment models take their starting points from this one because of its widespread recognition and success. This approach calculates the prepayment percentage annually and applies to each month of the loan or mortgage's term.

Prepayments are assumed to increase gradually throughout the first 30 months of the loan's term. Following that time, prepayments are expected to increase until the debt matures.

Specifically, the PSA has a CPR of 0.2% in the first month after genesis, rising by 0.2% each month afterward up to the 30th month. The PSA calculates a CPR rate of 6% on the unpaid debt after the 30th month.

Use Of A Prepayment Model In The Real World

The Securities Industry and Financial Markets Association (SIFMA) developed the PSA Prepayment Model in 1985, making it one of the most well-known prepayment methods. (The predecessor of SIFMA was the Public Securities Association. The original name for the prepayment system is still in use.

Instead, the Bond Market Association PSA (named after an organization that joined with SIFMA in 2006) is another name for this concept. The PSA model anticipates a rise in prepayment rates over the first 30 months, followed by stable prepayment rates.

The baseline model, often known as 100% PSA or 100 PSA, forecasts that monthly prepayment rates would rise by 0.2% over the first 30 months until reaching a peak of 6% in month 30.

Notably, a prepayment rate of 9% would be assumed for a 150% PSA, while a prepayment rate of 12% would be considered for a 200% PSA.