Another way of dividing the cash flows is by the type of payment is being made. Obviously the two types of cash flows associated with mortgages are interest and principal. In the absence of defaults or prepayments, the pricing of the IO and PO are fairly easy as the various cash flows are known with certainty. That is due to the fixed payments associated with most mortgages, the early cash flows are predominantly interest and hence go to the IO holders. However, there are defaults and prepayments which make these securities significantly more complex.
Borrowers have an option to prepay their mortgage.
This prepayment is generally without penalty. The two most common times a borrower would prepay is when the house is sold and when the property is refinanced. The latter of which generally occurs when interest rates decline. If we think of IOs and POs as bonds we would immediately conclude that their price moves opposite that of prevailing interest rates. Consider the case of IO holders.