They may sell the mortgaged property, come into unexpected funds and pay off all or part of the mortgage, refinance the mortgage, or retire the debt early. Generally, the most important factor affecting prepayments is refinancing to take advantage of lower interest rates. Again, several factors affect the pace of loan refinancing, including prevailing interest rates, home value appreciation, ease of the refinancing process, and local economic conditions. Prevailing interest rates are the most significant factor. When long-term interest rates fall, so do mortgage rates.
Prepayments tend to increase during periods of declining interest rates.
Borrowers take advantage of these rates by refinancing higher rate mortgages with lower rate mortgages and may repeat this process several times. On the other hand, when rates rise fewer borrowers refinance their loans and prepayments slow. Some tranches are dramatically affected by prepayment patterns. Under certain scenarios, investors in 10s and inverse floating-rate tranches may not receive their initial investment back, resulting in an actual loss on the investment. For this reason it is essential that investors understand the actual security that they are purchasing, as well as the underlying mortgages that provide the cash flows to the security.