What is Prepayment Modeling?
In all long term financings, there is always a risk that the borrowers pay the money early and pay lesser interest, hence taking the profitability down and causing cash flow management issues for the company. It may also result in new refinancing at lower rates. Therefore, institutions must do the prepayment modelling.
Borrowers may prepay their mortgages due to the sale or destruction of the property or a desire to refinance at lower prevailing rates. In addition, prepayments may occur because the borrower has defaulted on the mortgage and the lender is forced to sell the property to cover the mortgage. Moreover, many mortgages have partial prepayment privileges (curtailments) that may be used, especially when the borrower has excess cash available to do so.
Example of Prepayment Modeling:
One of the methods of modelling the prepayment is to model the incentive function. The incentive functions are modelled using refinancing activity and are based on the term structure of mortgage rates. Other items such as past rates and average loan size can be included in the model to help explain refinancing behaviour. Incentive functions essentially forecast the present value of any dollar gains, given that a borrower will refinance.