What is the impact of a prepayment that is less than the amount required to completely pay off a loan?

What will be an ideal response?

The impact on the borrower is that the principal (or amount required to completely pay off
a loan) is reduced by the amount paid off that period that goes beyond the interest due. The impact on the lender can involve risk and is captured by the concept of prepayment risk, whichis the risk associated with a mortgage's cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan's note rate. For example, if the note rate on a mortgage originated five years ago is 8% and the prevailing mortgage rate (i.e., rate at which a new loan can be obtained) is 5.5%, then there is an incentive for the borrower to refinance the loan.

The decision to refinance will depend on several factors, but the single most important one is the prevailing mortgage rate compared to the note rate. The disadvantage to the investor is that the proceeds received from the repayment of the loan must be reinvested at a lower interest rate than the note rate. This risk is the same as that faced by an investor in a callable corporate or municipal bond. However, unlike a callable bond, there is no premium that must be paid by the borrower in the case of a residential mortgage loan. Any principal repaid in advance of the scheduled due date is paid at par value. The exception, of course, is if the loan is a prepayment penalty mortgage loan.