Prepayment risk is 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. Prepayment risk has two main subcategories: contraction risk and extension risk.

The effects of repayment risk include:

• Cash flows occurring earlier than planned.
• The loan duration getting shorter than contractually set.
• The possible need to reinvest funds at lower interest rates (opportunity cost).