Pre-payment occurs when a borrower pays more than is due on the loan, causing the loan to be paid off earlier than originally scheduled. Sometimes this is done by doubling up on payments, and sometimes it is done by making a lump sum payment for the balance due on the loan.
You may be thinking why is this a risk? After all, when a loan is repaid in this manner you are receiving all of your principal back plus interest for the time the loan was active. This is true, and it is certainly better than having the loan go into default. However, it is worse for the lender than if regular payments had been made according to the 3-year loan schedule.
When the loan is pre-paid, and the lender re-invests the money it is possible that it will be done in worse market conditions (i.e. interest rates may have gone down). Also, the interest earned from the good loans in your portfolio offsets the money lost from bad loans that end up defaulting. So, if your good loans pre-pay then you are making less money on each good loan, which decreases overall earnings. In addition, it takes time to bid and re-invest the money, so the money may sit idle for a month or more after a repayment at no interest until it is reinvested.
There are a variety of reasons why a borrower might choose to pre-pay a loan.
- If their credit score improved they can refinance at a lower rate.
- If the money was for a short term need such as flipping a house or buying inventory they might re-pay once they have reaped the profits from their investment.
- They might accelerate payments to get out of debt quicker.
- They might choose to consolidate their debt to reduce the number of payments they are making to creditors.
Banks understand the risks associated with pre-payments, and it is the reason that some banks charge pre-payment penalties on loans that are paid off significantly ahead of schedule. I don't have any great advice for avoiding this risk, but as with all investment risk I think it helps to be aware of all risks associated with an investment when deciding to invest. Also, unlike defaults I don't fault the borrowers for this additional risk; if I was in the borrower's shoes I would also pre-pay a loan if doing so could save me money on interest payments.