Empowering the Student Borrower: Understanding Prepayment Risk

Since Louis Ranieri started touring the country peddling mortgage bonds to savings and loans institutions in the 1970’s, the largest concern in the amortizing consumer loan market has been the borrower’s ability to voluntarily refinance their loans at any time for no expense.  This problem is particularly important for longer term consumer loans such as mortgages and student loans: the consumer maintains a unique option contract on prepayment that no other market participant can efficiently access.  Lenders can hedge their interest rate risk through swaps and their default risk through credit default swaps, but they cannot hedge the prepayment risk because those contracts carry heavy prepayment penalties.  Lenders (or investors) can mitigate the risk by speculating on prepayment trends, but they can never fully hedge the prepayment risk.  As a result, there is a meaningful and unavoidable financial risk built into these consumer loans that is entirely dependent on the consumer’s behavior.  It is critical for student borrowers, or at least their financial advisors, to understand this structure because it creates a zero-sum game where any positive outcome for the borrower is an inherent negative outcome for the lender.  Under this scenario, students must be aware that lenders will be trying to persuade them to act against their own best interest and the consumer’s only recourse is to maximize the leverage of their prepayment option.  In order to do this, we need to understand prepayment risk.

There are two types of prepayment risk that arise because of a consumer borrower’s opportunity to refinance: interest rate risk and equity prepayment risk. 

Interest rate risk is very straightforward and arises from the consumer demand for fixed rate loans and the market’s willingness to lend on fixed terms.  From the consumer perspective, the logic is simple: if interest rates decline, the borrower can refinance their existing loans into a new and lower fixed rate.  This transaction has little or no cost to the borrower, so the outcome is purely beneficial to the consumer and purely detrimental to the existing lender.  Notably, this prepayment trend has nothing to do with credit risk and is entirely derived from interest rate risk.  Thus, interest rate risk can be quantified by forecasting changes in interest rates: falling rates increase prepayment while rising rates decrease prepayment.  Broadly speaking, the value of interest rate risk is derived from the volatility in prevailing interest rates over time. 

Equity prepayment risk is a little more nuanced and arises from changes in the borrower’s credit quality.  The logic is fairly simple: if a borrower’s credit quality improves materially over the term of the loan, then the borrower should be able to refinance their loans at lower rate – at a “tighter spread” to be technical.  Thus, equity prepayment risk can be quantified by forecasting changes in the borrower’s credit quality: increasing quality increases prepayments, decreasing quality decreases prepayments.  Broadly speaking, the value of equity prepayment risk is derived from the volatility in the borrower’s credit quality over time.  In contrast to interest rate risk, equity prepayment risk is entirely derived from credit quality and has nothing to do with prevailing interest rate risk. 

Mortgages and student loans each contain both interest rate risk and equity prepayment risk, but their relative significance varies widely between the two loan types.  For mortgages, prepayment risk is almost entirely concentrated in interest rate risk.  For student loans, prepayment risk is almost entirely concentrated in equity prepayment risk.  This fact has major consequences on the most effective repayment strategies for each loan type, a topic we will discuss further in the next post.

Byline:

Derek Kaknes