A prepayment is any payment that is made before its due date. Prepayments may be made for goods and services or toward settling a debt. They can be categorized into two groups: Complete Prepayments and Partial Prepayments.
A complete prepayment involves payment for the full balance of a liability before its official due date, whereas a partial prepayment involves payment for only a part of a liability’s balance. Understanding prepayments is important when performing financial analysis.
Use of Prepayments
Prepayments are used by individuals, corporations, and governments to settle accounts before they are due.
Individuals can settle future tax obligations with prepayments.
Individuals can pay for credit card charges in advance of their due date.
Individuals can prepay past debt before its due date by refinancing that debt.
Corporations can use prepayments to pay the wages of their workers.
Corporations can use prepayments to pay for rent for all lands used for business.
Corporations can prepay existing (short term and long term) debt by refinancing such debt.
Similar to corporations, governments can prepay wages and rents for public sector companies.
Governments can prepay existing international debt owed to another country or international organization by refinancing such debt.
If an individual, corporation or government makes a prepayment relatively early into the tenure of a loan, they can save a substantial amount in interest charges. Consider the following example.
Company XYZ borrows $200,000 from a bank at an interest rate of 15% per year for a period of 5 years. As per the terms of the loan, Company XYZ must make monthly payments to the bank. The monthly payment amounts to $4,758. At the end of the first year, Company XYZ would have paid $29,039 towards the principal and $28,057 as interest payment. Instead, if Company XYZ had prepaid the entire amount, it would have had to pay $57,422 less as interest.
Consider a second example. John has taken a loan worth $300,000 for a period of 5 years at 15% interest per year. By prepaying the entire loan, John will save $128,219. This is shown below:
Total Yearly Payment (A+B)
% Loan Repaid
John will have to pay $42,086 or 33% of the total interest in his first year of repayment. In his second year, John will pay $35,084 or 27% of the total interest amount. In his third year of repayment, John will pay $26,956 or 21% of the total interest amount. In his fourth year of repayment, John will pay $17,522 or 14% of the total interest amount. In his last year of repayment, John will pay $6,571 or 5% of the total interest.
From the above illustration, it is clear that if John were to prepay the entire amount early in the tenure of the loan, he would save substantially on his interest payments. In practice, if the objective of a borrower is to minimize interest payments, it is important to make the prepayment as early as possible into the repayment period. However, even at a later stage in the loan tenure, when the borrower would have already paid much of the interest, the borrower can still save on his interest payments by prepaying the loan at any time before the end of his repayment period.
In practice, complete prepayments are rare. After all, if the borrower has the ability to repay the entire loan amount relatively early on into the repayment period, why did he borrow in the first place? Partial prepayments are used by the borrower to reduce the principal amount. The reduction in the principal amount results in a decrease in interest payments.
Consider an extension of the example above. Suppose John makes a lump sum payment of $50,000 six months into his loan. John will then save 32% on his interest payment. This is shown below:
Rate of Interest
5 years or 60 months
5 years or 60 months
Partial Prepayment after 6 Months
Total Interest Paid
Often, banks charge a prepayment penalty. This is done to deter borrowers from making prepayments early into the repayment period so that the bank can extract a minimum amount of interest from the borrowers. For example, banks often do not allow prepayment of a loan within 6 months of borrowing.
In other instances, banks may charge a specific portion of the loan amount as interest in the case of prepayment.
Applications in financial modeling
In financial modeling, it’s important to have a clearly modeled debt schedule. The basic starting assumption is that all debts will be repaid when they are due. In order to determine when debts are due to be paid, an analyst can look in the notes to a company’s financial statements. If, however, there is a reason to believe the debts will be repaid early, the analyst should build that into the financial model and the resulting cash flow.