Contraction Risk

If you loan out money, especially if you do it for long periods of time (like with a mortgage), you don't want the borrower to prepay the loan. With a 30-year mortgage outstanding, you don't want the person to win the lottery a year into it and pay you back the remaining principal. You just lost out on 29 years of interest payments...hundreds of thousands of dollars.

That's known as prepayment risk. Contraction risk is a component of this. It's the risk that someone will pay off part or all of the loan in advance, cutting off all those juicy future interest payments.

The opposite form of prepayment risk is called extension risk. Instead of shortening the length of the loan (like with the contraction scenario), the borrower in this circumstance extends the loan. They refinance, or they defer loan payments. The borrower usually decides to do this when they can get a better deal on rates, say, refinancing a 6% fixed rate with a 3% one.