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Prepayment Risk


A type of risk that is associated with loans and loan pools (pooled loans, such as mortgage pools) in the case where borrowers repay a debt obligation before it comes due. This risk arises from early repayment of debt obligations, in part or in full, typically opting for refinancing to take advantage of lower interest rates. In other words, banks and financial institutions can face repayment risk if borrowers are granted the option to take advantage of lower interest rates by refinancing their loans on more favorable terms.

Repayment risk leads to cash flows occurring earlier than planned, shorter loan durations, and the possible need to reinvest funds at lower interest rates (opportunity cost). It has two main subcategories: contraction risk and extension risk.

In case the loan is a mortgage loan, this risk is referred to as a mortgage prepayment risk.



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