Prepayments

Prepayment assumptions are important considerations when measuring optionality risk, especially for mortgage-related products. Prepayment risk (or conversely, extension risk) on loans and mortgage-related securities are highly influenced by changes in interest rates. Prepayment assumptions may also be affected by factors such as loan size, geographic area, credit score, and type of rate (for example, fixed versus variable). It is critical that assumptions be reasonable for each rate scenario measured. For example, in an increasing rate environment, prepayment assumptions should typically reflect slower prepayments than in a declining rate environment.

Credit unions may actively track internal prepayment data or obtain prepayment data from external sources. Management should consider the reliability and applicability of external data and be aware that market stress, externalities, or a change in the credit union’s financial condition may influence membership behaviors.

Management should build assumptions around the characteristics of the credit union’s portfolio (for example, prepayment speeds for a portfolio of various types of real estate loans will have different assumptions). Further, management should aggregate assets before applying assumptions.

Last updated on December 06, 2024