Prepayment: When Borrowers Repay Early and What It Costs

Prepayment is principal handed back before the date it was due. Not a rupee goes missing, so nothing runs down the loss order and none of the three pieces absorbs anything. The calendar is what moves. The weighted average life shortens, and the money that came back has to be given a new job at whatever SPOT rate the day offers. Its cost is that the day is rarely a good one.

Everything below follows from a right that sits inside the loan document itself. A borrower may clear the amount owed ahead of schedule, the lender wrote that permission in, and once written it cannot be taken back. Whoever holds a claim on those loans is therefore standing at the far end of somebody else’s timing decision, made for that borrower’s reasons and on that borrower’s chosen day. The order of losses protects a holder against amounts that never turn up. The order was never built to protect anyone against amounts turning up too soon, and turning up too soon is what early repayment does.

Is early repayment the same event as a borrower failing to pay?

No. Both land on a holder wearing the same expression, so the two are worth pulling apart in the first minute. Both arrive as an unscheduled phone call. Both change what the structure receives. Everything after that is opposite.

Take the failure first. A defaultMoney a borrower was due to hand over and did not. The amount never arrives, so somebody downstream ends up short by exactly that much. means the money is simply not there. The pool was expecting a certain sum and a smaller sum reached it, and the difference is a shortfallThe gap between what a pool was supposed to collect and what actually reached it. Somebody has to absorb a gap; it does not close by itself.. A shortfall has to be borne by somebody, and the order of losses decides who. At Sarvani Receivables Trust, a trust written to carry this arithmetic, the equity piece meets a shortfall first, the mezzanine piece next, and the senior piece last of the three.

Now take early repayment. The money is there. All of it is there, before anybody asked for it. Nothing is short, so there is no gap for anybody to bear, so the order of losses is never consulted at all. A shortfall runs down the order and an early arrival never enters it. The same worried feeling therefore points at two completely different mechanisms.

Hold that separation from here on. Nearly every wrong reading of this subject begins by quietly merging the two, and once merged the reader starts looking for which piece got hurt. Nobody got hurt. The absence of anybody hurt is the whole difficulty.

What makes somebody hand back money they were allowed to keep?

Three ordinary things. A reader who cannot picture the borrower cannot picture the risk either, so all three are worth naming in plain language before any arithmetic.

The house is sold, and the loan goes with it. A household moves cities for work, or moves up a street, or moves in with an ageing parent. The property changes hands and the loan against it is cleared out of the sale proceeds. Nobody was thinking about rates that morning. The household was thinking about school admissions.

Money turns up, and the borrower would rather owe nothing. A bonus lands, a plot in the village is sold, a retirement amount is paid out. Plenty of households carry a real dislike of owing money and will clear a loan the moment they can, even where a spreadsheet would tell them to keep it running. Clearing a loan out of dislike for owing money is not a mistake. It is a preference, and preferences pay off loans.

The same money can be borrowed elsewhere for less. Here the borrower goes out, raises the same amount from somewhere else at a lower SPOT rate, and uses the new borrowing to close the old loan. Closing the old loan that way is refinancingClosing one loan with money raised somewhere else, normally because the new lender is willing to charge less for it., and refinancing is the reason that matters most of the three.

Why does the third one matter more than the other two? Because of what it is attached to. The first two reasons arrive for private reasons that have nothing whatever to do with whoever holds the claim; the third arrives for exactly the reason that makes the returned money least useful on the day it lands. A wave of the first kind is scattered noise. A wave of the third kind is not noise at all, and the next block is entirely about that.

Ranking the three would rest on how frequently each of them occurs, and nothing on this platform counts that. Naming three reasons honestly is worth more than ordering them dishonestly.

Why does the money come back on the least useful day of all?

Early repayment is called a risk for one reason. Every rupee arrives, in full, ahead of time. If that were the end of it, the correct response would be a shrug and a bank deposit. The shrug is wrong, and the reason is timing that leans one way.

Follow the refinancing borrower through. The borrower goes looking for a new loan because the SPOT rate at which they can raise money has fallen. Down goes the cost of borrowing, out goes the application, in comes the new lender, and the old loan is cleared. Fine. Now stand where the holder stands. The old loan was one of thousands inside the pool, and its principal has just been handed over. The returned principal has to be placed again somewhere. At what rate?

At the rate the day offers, and the day offering it is the very day a fall in the SPOT rate made refinancing worth doing in the first place. One movement produced both events. The fall caused the money to come back, and the same fall set the terms on which the money can be put back to work. The two are not independent, and they are not independent in the direction that hurts.

Run the mirror image and the lean shows itself properly. Suppose instead the SPOT rate at which borrowers can raise money rises. Refinancing into a costlier loan is silly, so nobody refinances. The old loans stay exactly where they are, paying their old rates, on their old dates. So the money a holder would now dearly love to have back, to place at the better rate on offer, is the money that stays out. Money that has come back turns up exactly when fresh work for it is worst paid, and money a holder would like back stays out exactly when fresh work for it would be best paid. The pairing is a lean, not a coin toss.

No arrangement of pieces can do anything about this. Splitting a pool into a senior, a mezzanine and an equity piece decides who bears a shortfall. The split does not decide when money arrives. Who absorbs losses can be rearranged all afternoon and the calendar will not notice.

The size of the lean is a different matter from its direction. The DIRECTION follows from the mechanism, so stating it costs nothing. Stating the SIZE in rupees would need a view about what SPOT rates will be on future dates, and this platform holds no such curve. So the direction is written down and the size is left alone.

Does a pool repay early all at once, or a little at a time?

One loan is a switch. The household either clears it in month forty or it does not; there is no half-cleared loan sitting on the table. If a pool held four loans, early repayment really would be a series of events, countable one by one.

A pool holds thousands. The borrowers do not know each other, they live in different cities, they move house for unrelated reasons and they read about rates on different days. So what reaches the structure in any period is not an event at all. A share of the principal arrives ahead of its date, made up of many small decisions taken independently, and then another share the next period, and another after that.

Early repayment on a pool is therefore described as a shape rather than as a happening: the honest handle on it is the schedule of principal, and the honest summary of a schedule is one number. The one number is the weighted average life.

Here is the everyday version of the same jump. One shop on a street shutting for a week is news. Twenty per cent of a market’s shutters being down on any given Tuesday is not news; it is a pattern, described with a fraction rather than with a story about the shopkeeper.

The missing quantity has a name. A repayment speedThe share of a pool’s principal that arrives ahead of its dates across some stretch of time. Measuring one takes real pools followed across years. is the number that would size that fraction, and no such measurement stands behind these drawings. The figure below therefore shows slivers with no scale on them. Uncomfortable, and also the truth.

What happens to the 2.50 years once the money is pulled forward?

Now the arithmetic, on figures already in hand. Rs 1,200 crore of receivables sit inside Sarvani Receivables Trust. The base calendar for those receivables was declared earlier in this sequence: four equal annual instalmentsOne of several amounts paid on stated dates, so an obligation is cleared in steps instead of in one payment at the end. of Rs 300 crore, one landing at every year end from the first through to the fourth, and a weighted average lifeA single figure summarising when principal comes back, with each amount counted according to its size. It was settled earlier in this sequence and is not rebuilt here. of 2.50 years. Take both as given; they are not rebuilt here.

A second calendar is declared here, for that same pool. Year one takes Rs 600 crore of the principal home. Each of the three years behind it takes Rs 200 crore. Add those up: 600 plus 200 plus 200 plus 200 gives Rs 1,200 crore. The same pool, all of it, not a rupee missing. Only the dates changed.

Work the summary number the same way it was worked before. Take each amount, weight it by how long the wait for it was, add the results together, then divide by the pool.

The middle columns are in crore-years, an ungainly unit and a useful one. Crore-years are rupees multiplied by waiting time, and crore-years are what actually falls when money is pulled forward. Under the base calendar the pool accumulates 3,000 of them. Under the front loaded shape it accumulates 2,400. Both divide by the same Rs 1,200 crore, so the plan that measured 2.50 years now measures 2.00. Half a year has come off it, and nobody asked the holder.

The middle columns show where the movement came from, so read them once more. Year one contributed 300 crore-years under the base calendar and 600 under the front loaded one. Twice as much money arrived, so the contribution is larger. Every later year contributed less. The gain at year one is 300 crore-years; the losses at years two, three and four are 200, 300 and 400, adding to 900. Net, 600 crore-years came out, and 600 divided by 1,200 is exactly the 0.50 years the summary number moved.

If the calendar moved, why did the three pieces not move with it?

Worth stopping on. A reader who has just watched a summary number slide half a year expects something else to have slid with it. Nothing did.

Go down the amounts one at a time and check each against what it was before a single date was touched.

Five rows, and the right-hand column repeats the middle one all the way down. Three of those shares close on 100.0, and they did before as well. In rupees the senior piece funds Rs 960 crore of that pool, and it funded exactly that much yesterday.

The reason fits in one sentence. The order of losses is an arrangement for handling amounts that are missing, and early repayment makes nothing missing, so the order is never called on at all. A structure has two separate questions running through it: whether the money comes, and when it comes. The pieces answer the first. The schedule answers the second. Moving one has no mechanical route to the other.

The household version shows the same thing. Suppose three people have lent to one shopkeeper on the understanding that if anything goes wrong, the youngest cousin loses money before the uncle does, and the uncle before the bank. If the shopkeeper repays everybody in eight months rather than twenty four, that understanding has not changed by a paisa. The understanding has simply never been needed. It stands there, intact and idle, exactly as before.

Where the returned principal goes once it has landed inside the structure is a genuinely separate question with its own answer, and it belongs with the payment order, covered separately.

Is anybody paid for having their calendar rearranged?

Sometimes, in some arrangements; the question can be stated here even where the answer cannot. Both are worth having.

The question is straightforward. In certain loan arrangements a borrower clearing the amount ahead of date pays a stated sum for doing so, and that sum is the compensation for the timing that has just been taken away from the lender. Where it exists, the money flows through to whoever holds the claim, and the cost of the rearranged calendar has a price attached to it.

Now the two reasons nothing is written in the box here. The first reason is a rule, and the second is a gap in this record, and they are shut for different causes.

Whether any such amount may be charged at all, on which kinds of loan, in what form and up to what size is set by the Reserve Bank of India at rbi.org.in. The wording gets revised, so the item is named and left where it lives.

The second route to a number would be a comparison. Take what a piece pays, set it against what an otherwise identical claim without the borrower’s early repayment right would pay, and the gap between the two is what the market charges for the timing. Run that here and it stops immediately: Sarvani Receivables Trust declares no rate on the senior piece, none on the mezzanine piece and none on the equity piece. Without a rate there is nothing to compare, and there is no second claim to compare it with either.

So nothing goes in the box, and the reason goes in instead. A cell left blank that names what is missing is a better thing to hand a reader than a number somebody filled in to be helpful.

Where does this turn up already, without a loan being involved?

A landlord lets a shop on the corner for three years at a fixed rent. The agreement was signed and the space was gone, so two other tenants who asked about the same shutter were turned away. In month seven the shopkeeper walks in, hands over the keys, and settles every rupee of rent owed to that day. Nothing is outstanding. Nothing was breached. The shopkeeper simply stopped.

Count what the landlord has lost. In rupees, nothing whatsoever. Every payment due arrived and arrived on time. Count what the landlord no longer has, and the list starts filling up. The twenty nine months of rent that were planned around have gone. The shutter is down. Two other tenants have taken shops elsewhere. And the going rent on that street today is whatever it is today, more than the agreement carried or a good deal less.

Nobody did anything wrong here, and the landlord is still not where the plan said they would be. Early repayment does exactly that to a structure, and no more. Notice also that the landlord has no complaint to make and nobody to make it to. A complaint needs a breach, and there was no breach.

One more thing the shop makes visible. If the street has gone quiet since the agreement was signed, and shops are letting for less than they were, the shopkeeper is more likely to have moved on and the landlord is more likely to face a lower rent when re-letting. The two arrive together, from the same cause. Change the shop for a loan and the rent for a SPOT rate and the arrangement is the one described here.

What does this change for the people on the receiving end?

Three of them, doing three different jobs, and each one changes something specific rather than merely worrying.

A lender that funds long loans with short money. Suppose the deposits behind a book of home loans are being rolledReplaced at the end of their term by a fresh deposit for another term, at whatever rate applies on that day. every year while the loans themselves run for many. When the loans come back early, that lender is suddenly holding cash it must place somewhere, and the somewhere is priced by the same fall in the SPOT rate that brought the cash home. The lender takes away a plan, not a forecast. The plan covers the day money turns up unasked, and it is worked out before the day arrives rather than during it.

An analyst reading a structure’s own paperwork. The first thing to look for is whether the schedule of principal being shown is an observation or a declaration. A declared calendar is fine, provided the paper says it is declared. A calendar quietly presented as though somebody had watched it happen is not fine, and the difference between the two is often a single sentence in a footnote. The second thing to look for is whether the summary number quoted anywhere in the document was worked on that same calendar or on a different one.

A household on the other side of the arrangement. Every borrower with a home loan holds the right described here, and holding it is worth something even if it is never used. The household version of the question is whether clearing the loan early is the best use of a lump sum that has just arrived, and that is a decision with a great many personal moving parts, settled outside this material.

All three share the shape of the work. None of them tries to predict when the money will come back; each of them decides in advance what happens if it does. That is the practical difference between treating early repayment as a surprise and treating it as a known feature with an unknown date.

What is the one number that would size all this?

By now the obvious question has arrived, and it is the right question. What fraction of a pool like this actually comes back ahead of date in a year?

The honest answer is that a declared calendar cannot supply it. Answering it means measuring real pools across real years, watching what arrived and when, and no such measurement stands behind these figures. A plausible invented fraction is worse than an admitted gap. Such a fraction gets quoted, and once quoted it stops being labelled as invented. The figure is therefore left blank rather than filled with something that sounds about right.

Three separate absences sit behind that, and they are worth listing separately rather than lumping together.

The structure above fixes three sizes and one order, and it fixes nothing at all about how often anything happens, so no sentence anywhere above attaches a likelihood to any piece. A reader instinctively converts the order into a statement about safety, so the absence of any frequency is worth saying in the same breath as the order itself. The order is not such a statement. It says who absorbs before whom. How often anybody absorbs anything is a different question, and this material does not contain its answer.

None of the three pieces is graded here. None is assessed. None is called safe, and no view is offered on whether holding any of them is a sensible thing for anybody to do.

Where did every rupee above come from?

Sarvani Receivables Trust was never a company. Somebody wrote it, and that somebody was building a teaching example. Its Rs 1,200 crore of receivables were sized here. So were the three pieces funding them, and so was the order in which they take losses. Putting a real business behind invented arithmetic is how a reader ends up believing the arithmetic, so no originator, servicer, trustee or arranger carries a company name anywhere above.

Both calendars above are declarations. Four instalments of Rs 300 crore came forward from earlier in this sequence, where they were declared in exactly the same spirit. The shape that pulls Rs 600 crore into year one was declared here, so the arithmetic had a second calendar to run against. Neither was measured. Nobody watched a pool for a year to see what came back ahead of date. No model of early repayment and no curve of future SPOT rates stands behind these figures, and that is why one panel in the drawings has nothing inside it.

Rates here always say SPOT. Up and down point opposite ways depending on whether a rate or a price is being watched, so a movement is written as a rise in the SPOT rate or a fall in the SPOT rate rather than as a bare direction. Amounts run in Indian digit grouping. And no sentence above grades a piece, ranks a piece or suggests that anybody hold one.

Sarvani Receivables Trust, the landlord and the shopkeeper are invented.
Educational material. Not advice on any investment, tax, budget or market position.