Prepayment Privilege

A prepayment privilege extends a right to a debt holder to pay all or part of a debt prior to its maturity or ahead of schedule, usually without risk of penalty. Prepayment privileges are often elements of such debts as mortgages or automobile loans. They are in opposition to a prepayment penalty, which is the amount set by the lender as a penalty to the debtor for paying off a debt prior to its maturity to recoup a portion of the lost interest the lender had planned to earn.

Fixed-income securities that incorporate prepayment privileges are considered riskier to the debt issuer because they are not certain as to when they will receive the cash flow of incoming funds. Prepayment tends to occur when interest rates are low, and mortgage refinancing is viewed as favorable. For banks seeking to balance their assets with their liabilities, early retirement of credit facilities can significantly affect their risk profiles. However, to encourage housing ownership and protect consumers, Congress prohibits banks from adding prepayment penalties to credit products such as mortgages.

A prepayment privilege also rises for callable bonds. When a company wants to issue debt in the form of a bond, but worries interest rates will fall after issuance, they can add a call feature allowing them to "call" back the outstanding debt. Essentially, retiring or paying it off early. The call is a right, but not an obligation, for the issuer. In return for this right, a callable bond's coupon (or interest rate) is set higher than a noncallable (or straight) bond's coupon rate. The extra interest on a callable bond compensates bondholders for accepting the added risk a bond with a rich coupon will be prepaid before its stated maturity date. This is particularly aggravating for bondholders during a falling interest rate environment, but such is the risk to receive a higher yielding bond. In contrast to a mortgage, a callable bond will generally carry a prepayment penalty in the form of a call premium, which is the added dollar premium a callable bond settles at over the bond's par value.