Prepayment is early repayment of a loan by a borrower.
In the case of a mortgage-backed security (MBS), prepayment is perceived as a risk, because mortgage debts are often paid off early in order to incur lower total interest payments through cheaper refinancing. The new financing may be cheaper because the borrower's credit rating has improved or because interest rates are lower, but in either case, the payments that would have been made to the MBS investor would be above market rates. Redeeming such loans early through prepayment reduces the upside of credit & interest rate variance in an MBS. The downside of these variances (interest rates rises or creditworthiness declines) does not normally induce a refinancing (since the fixed mortgage payments are now at below-market rates). The fact that MBS-holders are exposed to downside prepayment risk, but rarely benefit from it, means that these bonds must pay a slightly higher interest rate than similar bonds without prepayment risk, to be attractive investments. (This is the Option Adjusted Spread.)
To compensate for the prepayment risk (which is a reinvestment risk), prepayment penalty clause is often included into the loan contract.
There are often soft prepayment terms versus hard prepayment terms. Soft prepayment terms can allow you prepayment without penalty under the terms of selling the home. Hard prepayment does not allow any exceptions without penalty. Bond issuers can overcome prepayment risks by issuing what are called super sinker bonds. Super sinker bonds are a bond with long-term coupons but a short-term maturity. Super sinkers are usually home-financing bonds that give bondholders their principal back right away if homeowners prepay their mortgages. In other words, mortgage prepayments are used to retire a specified maturity. Super sinkers are likely to be paid off in a relatively short time. As a result, holders may receive the higher long-term yield after only a short period.