Prepayments and the effective interest rate on mortgage portfolios

Mortgages are long contracts that borrowers repay early: they sell the property, refinance elsewhere when rates fall, or settle from bonuses and end-of-service payments. For a refinance company that bought loans at a premium or discount, the EIR depends heavily on how long the loans are expected to last, because the premium or discount and transaction costs are spread over the expected life, not the contractual term. When actual prepayments differ from the estimate, IFRS 9 requires the carrying amount to be recalculated at the original EIR with an immediate adjustment in profit or loss; this catch-up can be large and volatile. Prepayment penalties also need a clear policy, and the prepayment feature itself must be checked for SPPI.

Are expected prepayments estimated for each portfolio or pool (by vintage, rate type, borrower segment, loan-to-value) using the company's own and the originators' history, and are they included in the cash flows used to compute the EIR? How often are prepayment assumptions reviewed, and when actual speeds differ, is the gross carrying amount recalculated at the original EIR with the difference recognised immediately in profit or loss? Is the catch-up separated from ECL movements? Are prepayment penalties or early settlement fees allowed under local rules and the loan contracts, and are they consistent with 'reasonable compensation' so that the loans still pass SPPI? How are penalties received recognised: included in the EIR estimate, or recognised in profit or loss when the loan is repaid?

1. When computing the EIR at initial recognition, estimate expected cash flows considering all contractual terms, including prepayment options, but not expected credit losses; for a portfolio, prepayment estimates may be made on a pool basis where loans are similar.
2. Spread premiums, discounts and transaction costs over the expected life implied by those cash flows.
3. At each reporting date, compare actual and expected prepayments and update the estimate of future cash flows where it has changed.
4. When estimated cash flows are revised (other than for credit losses or a modification), recalculate the gross carrying amount as the present value of the revised cash flows at the original EIR and recognise the adjustment immediately in interest income or a separately disclosed line in profit or loss.
5. Do not reset the EIR because prepayments changed; for fixed-rate loans the original EIR is retained, while for floating-rate loans periodic re-estimation of cash flows to reflect market rate movements changes the EIR.
6. Assess the prepayment feature for SPPI: a prepayment amount that substantially represents unpaid principal and interest plus reasonable compensation for early termination is consistent with SPPI.
7. Apply a consistent policy for prepayment penalties: either include expected penalties in the cash flows used for the EIR, or recognise them in profit or loss on prepayment when the related loan is derecognised.

Catch-up adjustment = present value of revised expected cash flows at the original EIR minus the gross carrying amount before revision. For a portfolio bought at a premium, faster prepayments shorten the expected life and produce a catch-up charge (the remaining premium must be absorbed sooner); for a discount portfolio they produce a catch-up gain. Prepayment speeds are usually modelled as an annual conditional prepayment rate by pool, with assumptions linked to the interest rate environment. The catch-up is not an impairment loss and should not be presented in the ECL line.

Disclose: (1) the policy for estimating expected life and prepayments in the EIR, and for prepayment penalties; (2) the amount of catch-up adjustments recognised in the period and where they are presented, if material; (3) prepayment assumptions as a key source of estimation uncertainty where a reasonably possible change could cause a material adjustment, with sensitivity; (4) interest rate risk disclosures that reflect expected rather than only contractual repayment profiles where that is how risk is managed; (5) the SPPI judgment for prepayment features where significant.

• Amortising premiums over the contractual term (often 20 to 25 years) when loans are expected to repay much earlier
• never updating prepayment assumptions after purchase
• adjusting the EIR prospectively when prepayment speeds change instead of recognising a catch-up
• burying catch-up adjustments in ECL or other income without disclosure
• recognising prepayment penalties as fee income under IFRS 15
• ignoring local consumer rules that cap or prohibit early settlement charges when estimating cash flows