# Understanding Prepayment: Definition, Types, and Potential Penalties

![Young couple calculating bills at home using a laptop and calculator. ](https://www.investopedia.com/thmb/WEAHMa3k5_jU-uP8RW5rkJ0ZIGw=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/GettyImages-1414921475-5617b7bdc1584b70a9811780ecb75c00.jpg)

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> **Definition**
>
> A prepayment is the satisfaction of a debt before its official due date. It can apply to goods, services, or loans.

## What Is a Prepayment?

Prepayment refers to settling a debt before its due date, affecting various financial aspects like loans and expenses. Both corporations and individuals may choose to prepay obligations to potentially save on interest or manage financial accounts effectively. However, certain loans, including mortgages, may carry prepayment penalties. Understanding the nuances of prepayment can guide informed financial decisions.

### Key Takeaways

*   Prepayment involves settling debts or expenses before their due date, often to reduce interest costs.
*   Both corporations and individuals may engage in prepayment, but the motivations and implications differ between the two.
*   Prepayment penalties may apply to certain loans, though many federal and state laws restrict these charges.
*   Corporations treat prepayments as current assets that are converted to expenses when the related goods or services are utilized.
*   Loan prepayments reduce the interest earned by lenders, which is why some may impose penalties.

## Delving Deeper Into Prepayments

Debts and obligations can often get settled in advance through prepayment. Corporations might prepay rent, wages, [revolving lines of credit](https://www.investopedia.com/terms/l/lineofcredit.asp), or other short-term or long-term debt obligations.

Consumers can prepay credit card charges before receiving a statement. Or they might [pay a loan off early](https://www.investopedia.com/pay-off-personal-loan-faster-8412361) by refinancing the debt through another lender or by paying the entire debt out of pocket.

Some loans, like [mortgages](https://www.investopedia.com/terms/m/mortgage.asp), might have a prepayment penalty. Lenders must disclose whether a loan includes a prepayment penalty, and borrowers must agree to the provision when they take out the loan. Furthermore, some state and federal laws prohibit or restrict these types of prepayment penalties.

The penalty may only apply to paying off the entire balance, generally by [refinancing the mortgage](https://www.investopedia.com/terms/r/refinance.asp). A borrower can usually make intermittent extra payments of the [principal](https://www.investopedia.com/terms/p/principal.asp) without penalty.

> **Important**
>
> A prepayment can settle the entire liability or partly reduce a loan balance before its due date.

## Exploring Various Types of Prepayments

Prepayments occur often in various situations, made by individuals and large businesses alike.

### 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 used or consumed. A [prepaid expense](https://www.investopedia.com/ask/answers/052815/how-are-prepaid-expenses-recorded-income-statement.asp) is first categorized as a [current asset](https://www.investopedia.com/terms/c/currentassets.asp) on the company's [balance sheet](https://www.investopedia.com/articles/04/031004.asp).

For example, a company can list $6,000 as a current asset under the prepaid rent account on its [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp) if it rents office space for $1,000 per 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](https://www.investopedia.com/ask/answers/122314/whats-example-pl-statement.asp) 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 spends $1,000 on a card and pays it off on the 30th day, it's a prepayment since the bill is due in another 30 days. The consumer's credit card company tracks these prepayments, so there is little need for the consumer to account for them personally.

### Prepayment by Taxpayers

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

The [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) typically requires self-employed individuals 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.

## Understanding Prepayment Penalties: What You Need to Know

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.

Passed in 2010, the [Dodd-Frank Act](https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp) prohibits lenders from assessing prepayment penalties on government-backed loans, including those from the [Federal Housing Administration (FHA)](https://www.investopedia.com/terms/f/fhaloan.asp), the [U.S. Department of Veterans Affairs (VA)](https://www.investopedia.com/terms/u/us-department-veterans-affairs.asp), and the [U.S. Department of Agriculture (USDA)](https://www.investopedia.com/terms/u/usda.asp).

For other mortgages, Dodd-Frank stops penalties beyond the first three years. Further, many states have laws prohibiting prepayment penalties on mortgages and other loans.

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

## Why Do Lenders Not Like Prepayments?

Lenders dislike prepayments because they lose out on the interest paid, as a prepayment shortens the loan term. If enough borrowers prepay their loans, lenders also face increased [interest rate risk](https://www.investopedia.com/terms/i/interestraterisk.asp), meaning the potential for investment losses.

## Why Is Prepayment a Risk?

Prepayment is primarily a risk for lenders and investors, who lose out on the value of interest payments over time. [Prepayment risk](https://www.investopedia.com/terms/p/prepaymentrisk.asp) is highest for fixed-income securities such as mortgage-backed securities.

## What Is the Difference Between a Deposit and a Prepayment?

A deposit represents a partial payment to place a hold on a product or service, such as a reservation. A prepayment can represent paying for a good or service before receiving delivery. A prepayment can also involve a borrower paying off all of a loan's outstanding balance before the loan's end date.

## The Bottom Line

Prepayment involves settling a debt or expense before the due date, which can benefit both individuals and companies. Individuals often prepay to reduce interest costs, while corporations may prepay expenses for accounting reasons. Prepaid expenses, like rent, are logged as assets in corporate accounts.

While prepaying loans such as mortgages or auto loans can be beneficial, it's crucial to check your loan contract for any prepayment penalties. Some loans, particularly under certain state and federal regulations, may restrict such penalties, so understanding your specific loan terms is essential before deciding on prepayment.

> **Article Sources**
>
> 1.  Internal Revenue Service. "[Self-Employed Individuals Tax Center](https://www.irs.gov/businesses/small-businesses-self-employed/self-employed-individuals-tax-center#payments)."
>     
> 2.  Experian. "[How Much Does a Prepayment Penalty Cost?](https://www.experian.com/blogs/ask-experian/how-much-does-prepayment-penalty-cost/)"
>     
> 3.  Congress.gov. "[H.R.4173: Dodd-Frank Wall Street Reform and Consumer Protection Act](https://www.congress.gov/bill/111th-congress/house-bill/4173/text)." Page 774.
>     
> 4.  Consumer Financial Protection Bureau. "[What Is a Prepayment Penalty?](https://www.consumerfinance.gov/ask-cfpb/what-is-a-prepayment-penalty-en-1957/)"