Understanding Prepayment Risk: Impact on Investors

Prepayment risk is something that you need to be aware of as an investor. Here are the basics of prepayment risk and how it can affect you as an investor.

Prepayment Risk

Prepayment risk is the risk associated with getting the principal amount back before you plan on getting it. For example, if you invested in mortgages, someone could decide to refinance his loan or sell his home. At that point, you would get all of your principal back, and the interest payments would cease. When you get involved in the mortgage market, you have to be aware that this could happen at any point. It is a risk that is associated with that type of investment and understood by investors.

Investment Considerations

Even if you do not have enough money to invest in the mortgage market, this risk could still affect you. For example, this situation sometimes comes up in the bond market. If a company has a call option when the bonds are issued, they could decide to redeem the bonds at any point. Therefore, the higher the rate of interest that is associated with this type of bond, the higher prepayment risk you are taking on as an investor.