What is a Home Equity Prepayment (HEP) Curve?
A home equity prepayment (HEP) curve measures prepayment scenarios for home equity loans. It is used by lenders to identify likely prepayments of principal on home equity loans. When a borrower prepays principal, it reduces the amount of principal still outstanding and subject to interest. It also reduces the total repayment time. It, therefore, reduces the lender’s yield from its investment.
A HEP curve does not model actual prepayment behavior. Instead, it uses historical performance to model expected future behaviors.
- Home equity prepayment (HEP) curves were designed to capture the shorter seasoning period on a home equity loan versus that of a traditional mortgage loan.
- A HEP curve has a 10-month ramp-up period before reaching a constant rate thereafter.
- HEP curves use historical data to model future predicted prepayment behaviors.
How a HEP Curve Works
In order to understand how a HEP curve works, here are some important definitions.
Conditional Prepayment Rate (CPR)
A conditional prepayment rate (CPR) estimates the likelihood that a pool of loans will be paid off prematurely. It is important to lenders because principal that is paid off early is no longer subject to interest. In order to accurately track expected interest income, lenders want to know the likelihood of prepayments.
CPR is presented as an annualized amount. A CPR of 6% means that 6% of the pool of current outstanding loan balances will likely be paid off prematurely in the next year.
Home Equity Loan
A home equity loan is a type of loan that borrows against the equity a borrower has accumulated in their home. Home equity is the difference between the home’s current market value and the amount of any pre-existing home mortgage loan. A home equity loan is often a second mortgage, subordinate to the original mortgage. It tends to charge a higher interest rate than a primary mortgage.
Home equity loans have a faster seasoning period than traditional mortgages. The term “seasoning” refers to the age of the loan. Loans become less risky to the lender over time as the borrower establishes a credit history and pays on schedule.
For traditional mortgages, holding periods under a year are considered to be unseasoned. Lenders usually will not allow borrowers to cash out equity or take a home equity line of credit (HELOC) while the mortgage is considered to be unseasoned. For home equity loans, the seasoning period is 10 months.
A HEP curve accounts for the faster seasoning period on home equity loans versus that of a traditional mortgage. Home equity prepayment curves have a 10-month seasoning ramp, with equal monthly increases until reaching a plateau at the final percentage in the 10th month.
According to the Global Financial Markets Institute, a National Association of State Boards of Accountancy–registered sponsor of continuing education for certified public accountants (CPAs), the standard home equity prepayment curve begins at 2% CPR in the first month and increases 2% per month until it plateaus when it reaches 20% in the 10th month.
Why Is Loan Seasoning Important?
The longer you have had a mortgage open, and the longer you have paid on time, the less risky you become to a lender. This is why lenders set a waiting period before you can refinance a loan.
What Is the Purpose of Home Equity Prepayment (HEP) Curves?
Lenders use HEP curves to identify what percentage of their loans will be prepaid. It helps them anticipate the amount of interest income they can expect to receive on a pool of outstanding loans.
Who Designed the HEP Curve?
The HEP curve was developed by Prudential Securities based on the observed prepayment behavior of $10 billion in historical home equity loans.