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4 Min. Read

What Is a Prepayment? Definition & Example

What is a Prepayment? Definition & Example

Loans are a large part of the business. There are a number of loans that a business may see. Depending on the size of the business, there may even be personal loans involved. As such, understanding the financial terminology around loans is one of the keys to success. If you’re learning about lending, you may have come across the term prepayment. Learn more about what a prepayment is, and how it can help or hurt you, here!

Here’s What We’ll Cover:

Defining the Term Prepayment

Other Types of Prepayments

Key Takeaways

Defining the Term Prepayment

Prepayment seems simple enough, right? Breaking it down using common language, it means payment before. When it comes to accounting though, it becomes more specific. As an accounting term, prepayment refers to the settlement of an instalment loan ahead of its official due date. It can also be applied to other types of debts (like credit card debt). This seems like a positive thing, correct? Unfortunately, it isn’t quite as simple as that.

Prepayments can lead to positive circumstances, as well as negative ones. They can be used to take care of an expense, making it a prepaid expense. This is especially helpful in situations like rental agreements, or upcoming services. However, when it’s applied to a loan, the results of prepayment become more complex.

Prepayments Can Result in Extra Payments

Some instalment loans come with a prepayment penalty fee. You’re most likely to see this in a mortgage loan or hear about it when discussing loans with a mortgage lender. But why do some loans come with prepayment penalties? It has to do with structure.

Instalment loans are built on specific time periods. These time periods allow lenders to forecast an accounting period. For example, 30-year mortgages are built to be paid back over 30 years. By creating a loan term with a set end date, a lender can predict how much money they’ll be making for that entire period of time. They’ll know exactly what is being paid back based on the principal loan and can normally predict the amount of money they’ll make on interest. This ability to forecast is crucial.

Now, if the loan is paid back early, then they’re going to be thrown through a loop. They won’t have that steady stream of income they were expecting. They’ll also be losing money based on the interest. As such, most mortgage lenders have a prepayment clause in their loan terms and agreements. This clause is a safety net that allows them to collect any lost money as the result of a loan being paid off early. All of that information can be found in the loan documents provided by a lender.

Other Types of Prepayments

Now that we’ve talked about the riskiest prepayment, a mortgage prepayment, let’s take a look at other types.

Corporate Prepayments

In the corporate world, expenses are the most common type of prepayments. Expenses are prepaid in one accounting period. However, the goods and services being paid for will be consumed in future periods. This is advantageous for businesses. When an expense is prepaid, it’s counted as a current asset on the company’s balance sheet. Then, when the asset is used or consumed it’s reclassified as a normal expense.

This is most commonly seen in expenses such as rent or services. If a company pays rent ahead of time, then they’ll reduce the amount of the current asset by the monthly cost until it’s completely consumed.

Prepayments by Individuals

Prepayments by individuals work similarly to corporate prepayments. However, they’re much easier to assess on personal accounting documents. This is due to the less involved nature of personal finances. Most commonly, prepayments by individuals have to do with credit card prepayments. A credit card balance can be prepaid by an individual before a statement is received.

Prepayments by Taxpayers

Taxpayers also have to make prepayments, though it’s not generally done voluntarily. HMRC requires that taxpayers that own businesses calculate their taxes. Then they require that they pay them. While this doesn’t seem like prepayment, it is applied the same way. The taxes are paid, then any overpayment is returned. If taxes aren’t prepaid, then penalties will be incurred by the business owner.

Key Takeaways

For the most part, prepayments are a savvy strategy to be used by corporations and individuals. However, it must be remembered that instalment loans may come with prepayment penalties. If you’re paying off an instalment loan, it may be better to avoid prepayment. For more articles like this one, be sure to check out our resource hub! It’s got plenty of helpful information for you and your business.