Prepayment

What Is a Prepayment?

A prepayment is any payment made ahead of its scheduled due date. The term is used in two main ways in finance. In lending, it usually means paying part or all of a loan's principal early. In accounting, it refers to paying for goods or services before they are received, such as an insurance premium paid for a future period. Both uses involve money moving earlier than the contract or calendar would normally require.

Prepayments on Loans

When a borrower makes an extra payment toward principal, the outstanding balance falls faster than the original amortization schedule. Because interest is charged on the remaining balance, later interest charges are lower, so the total cost of the loan generally decreases. Some loan agreements include a prepayment penalty, a fee charged if the borrower pays off the loan early. Borrowers often prepay when they sell a property or when they refinancing at a lower rate.

Prepayment Risk for Investors

Prepayment matters to investors who hold debt securities, especially mortgage-backed securities. These securities pay investors from the principal and interest of underlying home loans. When interest rates fall, many borrowers refinance, which returns principal to investors sooner than expected. The investor then has to reinvest that cash, possibly at lower yield levels. This uncertainty about timing is called prepayment risk. It concerns when cash arrives rather than whether it will be paid, and it is one reason mortgage-backed securities can behave differently from ordinary bonds.

Prepaid Expenses in Accounting

For businesses, a prepayment made for a future period is recorded as a prepaid expense on the balance sheet, which is an asset. The amount is moved to an expense on the income statement gradually, as the service is used up. For example, a twelve-month insurance policy paid in advance would be recognized over the year rather than all at once. This treatment keeps the company's reported expenses matched to the periods they relate to.