Prepayment: Definition, How It Works, Types, and Penalties

What Is Prepayment?

Prepayment is an accounting term for the settlement of a debt or installment loan in advance of its official due date. A prepayment may be the settlement of a bill, an operating expense, or a non-operating expense that closes an account before its due date. An individual, a corporation, or any other type of organization may make a prepayment.

Understanding Prepayment

Many types of debts and obligations are settled in advance through prepayment. Corporations might prepay rent, wages, revolving lines of credit, or other short-term or long-term debt obligations.

Consumers can prepay credit card charges before they actually receive a statement. Or they might pay a loan off early, by refinancing the debt through another lender or by paying the entire debt out of pocket.

Some loans, such as mortgages, may include a prepayment penalty. If a loan includes such a penalty, the borrowers must be made aware of and agree to the provision when they take out the loan. Further, some types of prepayment penalties are restricted by law.

The penalty may only apply to paying off the entire balance, generally by refinancing the mortgage. A borrower can usually make intermittent extra payments of the principal without penalty.

Types of Prepayment

Prepayments are common in a variety of contexts. Individuals and large businesses make prepayments.

Corporate Prepayments

In the corporate environment, expenses are the most common prepayments. These expenditures are paid in full in one accounting period for goods or services that will be consumed in a future period. The prepayment is reclassified as a normal expense when the asset is actually used or consumed. A prepaid expense is first categorized as a current asset on the company's balance sheet.

For example, a company can list $6,000 as a current asset under the prepaid rent account on its balance sheet if it rents office space for $1,000 a month and prepays six months' rent. The company would reduce the current asset by $1,000 in each subsequent month and would list the expense on its income statement as an operating cost of $1,000 as the total prepaid rent expenses are actually incurred.

Prepayments by Individuals

Individuals also make prepayments, and the personal accounting process is much easier. A consumer might run up a monthly credit card bill with a settlement date of 30 days after the end of the month.

If a consumer incurs $1,000 of total expenses on the card and pays it off on the 30th day of that month, it's considered a prepayment because the bill isn't actually due for another 30 days. The consumer's credit card company tracks these prepayments, so there is little need for the consumer to account for it personally.

Prepayment by Taxpayers

Taxpayers regularly—voluntarily or not—make a prepayment of taxes when part of their pay is withheld for taxes. Technically, taxes are due on or about April 15 each year, but their employers are required to withhold taxes in each pay period and send the money to the government on the employee's behalf.

Self-employed individuals are expected to make a prepayment of taxes by filing quarterly estimated taxes.

In either case, if they pay more than their taxes due for the year, taxpayers receive any excess back as a tax refund.

What Is a Prepayment Penalty?

Some lenders charge a prepayment penalty if you pay off your loan early. Prepayment penalties typically amount to 1%-2%, which can add up quickly if you're making a substantial payment. Loan types that may include prepayment penalties include mortgages, auto loans, and personal loans.

Since the passage of the Dodd-Frank Act in 2010, lenders have been prohibited from assessing prepayment penalties on government-backed loans such as FHA, VA, and USDA loans. For all other mortgage types, Dodd-Frank restricts lenders from assessing penalties beyond the first three years of the loan. Further, many states have laws prohibiting prepayment penalties on mortgages and other loans.

Mortgage prepayment penalties generally apply only when you pay off the entire outstanding mortgage balance at once. Making additional payments toward the principal rarely incurs extra charges.

Frequently Asked Questions (FAQs)

The Bottom Line

A prepayment is settlement of a debt or expense before the agree-upon payment date. Individuals and companies make prepayments, but individuals tend to do so in order to minimize interest charges while companies may prepay expenses as an accounting practice. Prepaid rent counts as an asset on a corporate balance sheet.

Individuals may prepay installment loans such as mortgages and auto loans. Lenders may be prohibited from assessing prepayment penalties for certain loans under state and federal law. However, it's always best to check the loan terms in your contract before committing.