The risk that a borrower will repay a loan before its maturity, depriving the lender of future interest payments. Prepayment risk is most important for callable bonds, in which the issuer may repay the principal and cease paying coupons after a certain date, and mortgage-backed securities, in which the mortgage holder may refinance his/her mortgage, which will result in the security holder losing future interest. Some callable bonds and mortgage-backed securities have structures embedded within them to reduce prepayment risk. See also: Collateralized mortgage obligation, Yield-to-worst, Yield-to-maturity.
The risk to a lender that part or all of the principal of a loan will be paid prior to the scheduled maturity. For a bondholder, prepayment risk refers to the possibility the issuer will redeem a callable bond prior to maturity. Prepayments generally occur when market rates of interest decline following the loan origination. Prepayment generally results in reduced cash flow for a bondholder when proceeds from the redemption are reinvested at a reduced interest rate. Also called call risk.
See option risk.