Can someone explain why the rate of prepayment for a mortgage increases per the PSA benchmark? I know how the formula works, but trying to understand why this is in the real world? Is it because people get richer as time goes on?
PSA measures the speed of prepayments. When rates go down, prepayments go up, but there is a plateau mark where it stays the same because of “prepayment burnout” which can happen for several reasons. Not sure if that helps or not, let me know
Hi Andrew, Thanks for your reply. I’m not sure that this answers my question. PSA does measure the rate of prepayment. But I think what it says per the 0.2% x t formula is that as time progresses the rate of prepayment increases. You are correct about the relationship between prepayments and rates, but I think we are talking about two different things.
PSA if I remember correctly increases up to 6% for every month. I.e. 30 months and you would reach that 6% (.2x 30). This assumes PSA of 100. If the PSA was 150, it would reach the 6% cap 1.5x as fast. There are also PSA collars on bonds that keep prepayments within certain ranges. FI was always one of my weaker areas so this may be off a bit.
As time goes by, more oppportunity for interest rate to change from where they were at inception and accordingly a higher probability for people to refinance.
The model does assume an increasing rate of prepayment with time. The 100% PSA refers to an increase of 0.2% per month until it caps at the 30 month mark. As to your question, its a approximation for the behavior in real world - mortgages are less likely to be refinanced or prepaid in the initial period. As time goes by, you see increasing amount of prepayments because a) the homeowners cash position improves with increasing wages b) people may tend to refinance with another bank after some time to avail better rates or to withdraw positive equity as cash.