Residential Mortgage Loans and Prepayment Mechanics

A residential mortgage is a fixed-income instrument with an unusual feature: the borrower holds a free option to repay the loan early (an early-exercise right, in effect), in whole or in part, at any time. This prepayment option destroys the regular coupon-bond math. When interest rates fall, borrowers refinance — accelerating principal return to investors at the worst possible time (when reinvestment rates are low). When rates rise, borrowers stay put — extending duration precisely when investors least want it. Before analysing mortgage-backed securities, you need to understand how individual mortgages amortise, how prepayment speeds are measured (CPR, SMM, and the PSA benchmark), and what drives prepayment behaviour (refinancing incentives, housing turnover, loan age, and burnout). These mechanics are the inputs to every MBS cash-flow model.