Conditional Prepayment Rate (CPR)

What Is a Conditional Prepayment Rate (CPR)?

A conditional prepayment rate (CPR) is an estimate of the percentage of a loan pool's principal that is probably going to be paid off prematurely. The estimate is calculated in light of a number of factors, for example, historical prepayment rates for previous loans like the ones in the pool and future economic standpoints. These computations are important for investors in assessing assets like mortgage-backed securities or other securitized heaps of loans.

Step by step instructions to Calculate Conditional Prepayment Rates (CPRs)

The CPR can be utilized for different loans. Pools of mortgages, student loans, and pass-through securities all utilization the CPR as estimates of prepayment. Commonly, the CPR is communicated as an annual percentage.

For instance, assuming a pool of mortgages has a CPR of 8%, that proposes that 8% of the pool's outstanding principal will be paid off prematurely in a given year.

The CPR assists investors with expecting prepayment risk, which is the risk implied with the premature return of principal on an income-creating security.

In simple terms, when a borrower takes care of a portion of their loan's principal early that portion stops causing interest and investors in that debt will never again receive interest payments from it. The risk of prepayment is most common in fixed-income securities, for example, callable bonds and mortgage-backed securities (MBSs).

What Does the CPR Tell You?

The higher the CPR, the quicker the associated debtors are probably going to prepay on their loans.

A high prepayment rate means the debts associated with the security are being paid back at a quicker rate than the required least. While this demonstrates that the investment is lower risk, since the amount that is owed is being paid back, it additionally means that the overall return on the investment is probably going to be lower.

Illustration of How to Use the CPR

The CPR can assist investors with measuring the logical return on an investment and their prepayment risk, particularly in changing economic conditions.

For instance, in a period of declining interest rates, homeowners frequently prepay their mortgages to refinance them at a lower rate. At the point when that happens, the mortgage-backed security that their mortgage is packaged into might be paid back sooner than expected, with the proceeds delivered back to the investor. The investor then needs to pick another security to invest in, which is probably going to have a lower rate of return since interest rates overall have dropped since their original investment.

Note that there is no prepayment risk with certain types of investments. Those incorporate noncallable corporate bonds and United States Treasury bonds (T-bonds), which don't consider it. Furthermore, collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs), issued through investment banks, might be structured so as to bring down the risk of prepayment.

Further, debt investments associated with a higher-risk tranche frequently make some more extended memories to maturity than those with a lower-risk tranche and carry less risk of being paid off right on time.

Single Monthly Mortality Rate (SMM) and CPR

Notwithstanding the CPR, which communicates prepayment risk in annual terms, investors can take a gander at an investment's [single month to month mortality (SMM)](/single-month to month mortality) rate. The not entirely set in stone by taking the total debt payment that is owed and contrasting it against the genuine amounts received for a specific month. It tends to be changed over into a CPR and vice versa.

Assume the total debt outstanding on a mortgage-backed security is $1 million and the payment owed for the month is $100,000 across the associated mortgages in general. Yet, when the payments are received for that month the genuine total is $110,000. That converts into a SMM of 1% (0.01 x $1,000,000).

Highlights

• A conditional prepayment rate (CPR) estimates the probable prepayment rate for a pool of loans, for example, a mortgage backed security.
• CPR is communicated as an annual percentage rate, while the single month to month mortality (SMM) rate measures prepayment risk on a month to month basis.
• The higher the CPR, the more prepayments are expected and the less interest the investor is probably going to receive altogether. This is called prepayment risk.