Interest Only Strips (IO Strips)
What it is:
How it works (Example):
Mortgages are paid in two parts, principal and interest. The total principal to be paid is predictable, whereas the interest paid is not predictable due to prepayments. The interest piece that is to be paid monthly is essentially stripped away from the rest of the mortgage to create another type of security called IO Strips.
Why it Matters:
Investors in IO strips must understand the risks involved if prepayments are made to the underlying mortgage pool. Primarily, prepayments will reduce interest costs and therefore cause payments to the IO holder to be lower. By contrast, in this case, principal only (PO) investors stand to benefit to the detriment of IO investors, as the PO holder will receive the same amount of money at a quicker rate.