Prepayment Risk

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Definition of 'Prepayment Risk'

Prepayment risk is the risk that a borrower will repay a loan earlier than expected. This can be a problem for lenders, as they may have to invest the money they receive from the loan repayment in other investments that may not be as profitable.

There are a number of factors that can contribute to prepayment risk, including:

* Interest rates: If interest rates fall, borrowers may be more likely to repay their loans early, as they can refinance their loans at a lower rate.
* The economy: If the economy is strong, borrowers may be more likely to have the income to repay their loans early.
* The borrower's financial situation: If a borrower experiences a financial windfall, such as an inheritance or a lottery win, they may be more likely to repay their loan early.

Prepayment risk can be managed by lenders in a number of ways, including:

* Charging a prepayment penalty: This is a fee that borrowers must pay if they repay their loan early.
* Using a balloon payment: This is a large payment that is due at the end of a loan term. This can help to discourage borrowers from repaying their loans early.
* Using an interest-only loan: This type of loan does not require borrowers to make any principal payments during the loan term. This can make it more difficult for borrowers to repay their loans early.

Prepayment risk is an important consideration for lenders, as it can impact their profitability. Lenders should carefully assess the potential for prepayment risk before making a loan.

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