What Are Accelerated Payments?
In finance, the term accelerated payments refers to voluntary payments made by a borrower in order to reduce the outstanding balance of their loan more rapidly.
Depending on the terms of the loan, accelerated payments may be an attractive option for borrowers wishing to minimize their total cost of borrowing. However, some loan structures disincentivize accelerated payments through prepayment penalties and other such provisions.
Accelerated payments are typically applied to a loan's principal, which reduces the outstanding balance and required interest in future payments. Overall, more accelerated payments result in a faster principal payoff, which can lead to substantial interest savings.
- Accelerated payments are voluntary additional payments made against the principal balance of a loan.
- They are permitted in many types of term loans, such as home mortgages, but can be subject to limitations and fees.
- The attractiveness of accelerated payments will depend on a number of factors, including the loan's interest rate and the opportunity cost of the borrower.
Understand Accelerated Payments
Accelerated payments are a common technique used by borrowers in a variety of financial contexts. A common example is that of home mortgage loans, in which borrowers are often allowed to make higher than mandated payments in order to pay off their principal more quickly. This, in turn, can result in a shorter amortization period and therefore a reduction in overall interest expenses.
These accelerated payment structures are common in various non-revolving loans, which are also known as term loans. These loans are structured using an amortization schedule which sets out the timing and amount of the loan payments. Each payment will have a component of interest and principal, with the percentage allocated to principal increasing gradually as the loan reaches maturity.
Depending on the terms of the loan, the amount of interest contained in each payment can be based on either a fixed or a variable interest rate. The higher the rate of interest on a loan, the more beneficial it can be to make accelerated payments. In fact, accelerated payments can benefit borrowers in two ways: in addition to reducing their interest expenses, accelerated payments can also increase the rate at which the borrower accumulates equity in the property being financed.
For instance, in a home mortgage loan, the borrower's equity in the home grows gradually as the principal balance of the mortgage loan declines. In addition to increasing the borrower's net worth, the growth of equity in a property can provide collateral for the borrower which they can use to finance subsequent purchases. This equity can also be leveraged in order to raise cash, such as through a mortgage refinance transaction.
Although accelerated payments can be advantageous, depending on the terms of the loan, it may not be economical to take advantage of this option. Some lenders include prepayment penalty clauses in their loan contracts, which either limit or levy fees against accelerated payments beyond a specified limit.
In mortgage lending, these kinds of prepayment terms are in fact quite common. Lenders will often limit accelerated payments to a maximum of 20% of the loan balance in each year. Additionally, lenders may impose additional penalties if the borrower seeks to refinance the mortgage or sell the underlying property before the end of the mortgage term. For these reasons, it is important to carefully consider the legalities of a loan in order to determine whether accelerated payments are truly economical.
Real World Example of Accelerated Payments
Michaela is a real-estate investor who recently purchased her first rental property. Reviewing her loan terms, she notes that her current interest rate is 3.50% and that the terms of her mortgage permit accelerated payments up to 20% of the outstanding principal balance in each year.
In weighing whether or not to make additional payments, she considers the pros and cons. On the one hand, making accelerated payments would save her the equivalent of 3.50% annual interest on the amount of payments she chooses to make. In this sense, making accelerated payments is equivalent to investing in an asset that produces a 3.50% annual return. Moreover, by making these payments, Michaela recognizes that she will be increasing her equity in the rental property, thereby increases the collateral available to her in order to finance her next real estate purchase.
On the other hand, given the historically low interest rate on her loan, Michaela also realizes that she may be able to find a higher return on her capital elsewhere. For instance, if she is able to raise money from other lenders or investors in order to finance her next purchase, she may be better off using her capital as a down payment for a second real estate acquisition, potentially earning significantly more than a 3.50% return.