Home Equity Prepayment (HEP) Curve

What Is a Home Equity Prepayment (HEP) Curve?

A home equity prepayment (HEP) curve measures prepayment scenarios for home equity loans. Lenders use it 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. Therefore, it 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.

How a HEP Curve Works

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's paid off early is no longer subject to interest. 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 likely will 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 that a borrower has accumulated in their home. Home equity is the difference between the home’s current market value and the amount of any preexisting 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.

Loan Seasoning

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.

HEP Curve

A HEP curve accounts for the faster seasoning period on home equity loans vs. 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.

The Bottom Line

A home equity prepayment (HEP) curve is a tool used by lenders to determine the likelihood of prepayments of principal on home equity loans. This is significant to assess because prepayment of principal reduces the amount of principal still outstanding that can be charged interest. It also cuts the overall repayment time and therefore reduces the lender's yield from its investment. A HEP curve uses historical performance to model expected future performance vs. modeling actual prepayment behavior.