Prepayment Option (Mortgages)
The prepayment option refers to the borrower's right to pay off their mortgage loan early, either in part or in full, before its scheduled maturity date. This is typically done through refinancing the loan at a lower interest rate or selling the property.
This embedded option in mortgages is the primary cause of Negative Convexity (MBS) in Other Loan Participants and Key Third Parties in the Mortgage Ecosystem (MBS). When interest rates fall, borrowers are more likely to exercise this option by refinancing, leading to increased prepayments. This limits the potential price appreciation of MBS because the higher-yielding underlying loans are retired early. Conversely, when rates rise, prepayments slow down, extending the duration of MBS and making them more sensitive to further rate increases.
References
- Vanguard. "Negative convexity in municipal bonds: The new rate regime and ..." corporate.vanguard.com.
- Touro University. "9.38 Negative Convexity – Fixed Income Mathematics." touro.pressbooks.pub.
Source material
- research add cross references to conceptsnegative convexity 2026 05 17
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