Friend or foe? Examining the impact of prepayments on loan returns

Loan portfolio management requires a keen understanding of various factors that impact returns. Yet far too often, credit union boards and decision-makers focus primarily on only one element: charge-offs.

While loan losses are certainly important, another critical, but often underestimated element that can have as much, if not more, of an impact on returns is prepayments. The purpose of this article is to show how actual prepayment speeds of your institution’s loans can significantly impact origination and purchase strategy.

Both prepayments and losses reflect the early termination of a loan, the former usually being voluntary on the part of the borrower, and the latter often being involuntary. While a loss always has a negative impact on return, prepayments can have a positive, negative, or even no impact on return, with the differentiation based on the price (or holding cost) at which the loan is owned.

From an investment perspective, it’s not the absolute level of either of the two performance metrics that matters; rather, what matters is how different they are from original expectations. Presumably, lenders incorporate their prepayment and loss expectations into the offered interest rate or purchase yield in order to meet their overall return goals.

Complicating matters, though, is that prepayments can be inversely correlated with interest rates, particularly for mortgages. Rising interest rates mean slower prepayments, which can have adverse consequences when longer-term portfolio returns are under consideration. Slow prepayments cause loans to be outstanding longer, resulting in missed opportunities to lend at higher rates. Conversely, when rates fall, prepayments rise, forcing reinvestment in the then-prevailing lower rates.

For example, consider a credit union originating 7% super-prime mortgages. Assuming a 10% CPR for prepayments, the yield on the loan becomes dependent on the cost of origination or purchase price of that loan. If the loan was purchased or originated at par, the yield (when quoted in monthly yield terms rather than semi-annual bond-equivalent and assuming no delay days) is the same as the interest rate: 7%. As a practical matter, however, most credit unions originate (or purchase) loans at premiums; even the points or other fees collected at origination often do not fully offset all of the costs of sourcing, underwriting, compliance and other expenses associated with generating a new loan. Therefore, the actual yield will be lower than the loan’s interest rate. The following table shows the no-loss yield at various origination costs from par to 102.50 with the assumed 10% CPR:

While we are using a mortgage loan in this example, the same analysis holds true for all loans, although the magnitude of the impact on yield will change; shorter loans, such as autos, will see a larger drop in yield due to prepayments given their shorter duration; for example, a 5-year auto loan at a 20% CPR will have a yield of 7% at a price of 100 (par), but at 102.50, a common holding cost, the yield drops to 5.58% (before losses).

But what happens if (or, more accurately, when) prepayments come in faster or slower than expected? This could arise from many factors, but, particularly in the case of mortgages, will often be driven by changes in general levels of interest rates. Slower prepayment rates associated with rising interest rates will generally be a positive for premium loans,^[1] while higher prepayment rates associated with falling interest rates will generally be a negative. However, these risks are not symmetric; prepayment rates will usually not decline below low single digits while prepayment rates can rise substantially should rates decline sufficiently, with speeds in excess of 30 CPR possible for short periods of time. The following table shows the change in the no-loss yields as prepayment speeds vary from the assumed prepayment speed of 10 CPR at the prices as set forth in the example above:

As previously discussed, there is no change in yield at par.  However, for all other price points, the yield changes when the CPR changes. For example, at a 102.5 price, a 4 CPR higher-than-expected prepayment speed – a variance from expectations that could easily occur should interest rates decline even a small amount – results in a 10 bps reduction in yield.

Just how volatile can prepayment speeds be? The following graph shows historical CPRs for FNMA 30-Year 6s (roughly a 6.5% gross coupon) for the last 20 years. To smooth out month-to-month noise, the graph shows 3-month average speeds. While this is not static pool analysis, as the cohort is changing, the graph provides a clear sense of the range of prepayment speeds possible from 5 CPR to 50 CPR over time.

A critical question is then: How does this change in prepayment speeds compare with the impact of losses on yield? The following graph shows the quarterly average net charge-off rate on first-lien mortgages for credit unions from just before the financial crisis to the end of 2023. As can be seen, outside of the effects of the financial crisis, net charge-offs have been near zero. Even at the worst of the financial crisis, net charge-offs remained under approximately 40 bps, and were only at those levels for a year or two. As 1 basis point of net charge-offs is roughly equivalent to a yield loss of 1 basis point, it’s clear that the impact of variations in prepayment speeds overwhelms the impact of variations in loss rates (unless loans are held at par).

When considering different sources for loans, evaluating and reviewing, on an ongoing basis, the actual prepayment speeds experienced by your institution are critical. In fact, for many loan assets like prime first lien mortgages, prepayment speeds are likely to have a larger impact on your overall returns than losses. Understanding (or setting forth) the original range of prepayment speed expectations for a particular loan source and then continually evaluating the outcome is a critical part of portfolio management.

^[1] This article does not address the opportunity cost of slower prepayment rates. Rather it focuses on the return of already originated loans through different prepayment assumptions.