Prepayment risk refers to the uncertainty that a borrower might repay earlier that 79specified in the loan documents.Most consumer mortgage loans (home mortgages) allow 80borrowers to prepay their loans in part or in full at any time before maturity.When might a 81borrower be likely to prepay a loan?There are many reasons (sale of the house when the loan 82has a due on sale clause, increased income levels, divorce, death, etc.), but we are most 83concerned with prepayment that is induced by changes in future mortgage interest rates.84Suppose a borrower obtained a mortgage loan 5 years ago at 7% interest.Further 85suppose that today's mortgage rate is 4%.It would make good sense for the borrower to get a

Version 8/13/20486new loan at the now lower rate and use the proceeds of that loan to prepay the old loan, thus 87reducing the cost of borrowing money going forward.When prepayment occurs in this situation, 88lenders who want to continue originating mortgage loans must now lend that money to another 89borrower at the now-prevailing interest rate of 4%.On the other hand, if the situation were 90reversed and the rate on the old loan is 4% and the now-prevailing rate is 7%, it is unlikely that 91the borrower will prepay the old "cheap money" loan.If you have studied option theory in a 92finance course, borrowers hold a put option and lenders face uncertainty about when/if borrowers 93may choose to exercise that option.(Lenders typically do not have a call option on mortgage 94loans.)As discussed here, prepayment risk can by considered part of interest rate risk just like 95inflation can be thought of as part of interest rate risk.(It is important to note here that 96investment property mortgage loans (in contrast to home loans to consumers) typically do not 97allow the borrower to prepay or, if prepayment is allowed, the borrower must pay a prepayment 98penalty to "make the lender whole.")

How could a prepayment penalty "make a lender whole" if the prepayment is driven by a drop in interest rates so that the now-prevailing rate is less than the contract rate? (Answer the question using the text above)