Extension rate refers to the percentage of loans in a mortgage-backed security (MBS) that are not repaid on the maturity date. In other words, it is the proportion of mortgages in a pool that has extended past its original maturity date. The extension rate is a critical indicator used in the financial industry to evaluate the performance and the risks associated with mortgage-backed securities.

When purchasing an MBS, investors need to understand the probability of borrowers defaulting on their loans and the length of time it may take to recover their principal. The extension rate is used to measure the potential risk to repayments and the expected duration of an investment. Typically, the higher the extension rate, the greater the risk to investors, as it means that the borrower is failing to repay loans on time, and the length of time it may take to recover the investment is prolonged.

The extension rate also determines the yield of an MBS. As the length of time for the repayment of principal is extended, the yield on the MBS will decrease. This attribute makes MBS particularly sensitive to interest rate fluctuations. The potential decrease in yield when extension rates increase is a crucial factor in determining the valuation and pricing of MBS.

Extension rates are closely monitored by financial institutions and investors to assess the credit risk of mortgage-backed securities. By evaluating the extension rates of MBS, investors and financial institutions can gain insights into potential risks and make informed investment decisions.