What is it?  It is the risk that a loan will pay off early. 

Why is it a risk? This is the tricky one.  On the surface it seem like a good thing.  Your loan paid off and it didn’t default. Great right?  Maybe, but probably not.

There is of course the cost of idle money, but that is not of much material contribution to the risk assuming fairly rapid reloaning of the money. 

To understand why this is a risk you must understand the typical default curves of a 3 year fully amortized loan.  (I am tracking the default curves on Prosper here, but they are not yet long enough to see the reason behind prepayment risk.)  Basically, a loan has the highest risk on defaulting in the first 18 months and the lowest thereafter.  It is not an either or, nor is it linear, but generally this is true and will be used in illustrate my point.

If you have a loan and it pays off at the 18 month you have indeed made your rate for 18 months, but now you must find another loan in which to invest the remaining principal and again be faced with the highest risk of default.  If that loan had not paid off you still would have made your rate (on the remaining principal), only this time with less risk of default.

Here is where I get hazy…  If I assuming continuous reinvestment and a well diversified portfolio (no more than 2% in a single loan).  What is the cost of prepayment risk?  I don’t think it is very high maybe only 1%.  The real answer depends on the shape of the default curves for the loans in your portfolio.  Sorry for this last bit of hand waving.  Anybody have a more rigorous tome on prepayment risk?

Questions, comments, screams of anguish? 

 

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