What Is a Paydown?
A paydown is a reduction in the overall debt achieved by a company, a government, or a consumer. In business, it often involves issuing a round of corporate bonds for less than the previous issue. In that way, the company reduces its debt load. For a consumer, a paydown can mean making a larger payment on a mortgage, car loan, credit card, or any other kind of debt to reduce the outstanding principal.
- A paydown is a reduction in the principal amount owed on a loan or other debt.
- Companies achieve a paydown by issuing a new round of debt that is smaller than a previous round that has reached maturity.
- Consumers can achieve a paydown by paying more than the minimum monthly amount due on a debt, such as a mortgage.
Understanding a Paydown
The goal of a paydown is to reduce the amount of principal owed on a debt. A payment on an interest-only mortgage loan, for example, would not qualify as a paydown. Nor would a payment on a credit card balance that does not exceed the regular minimum monthly payment plus the total of any new purchases. That's because the principal of the debt is not shrinking.
How Bond Paydowns Work
A company or a municipal authority can implement a paydown by issuing a new round of bonds with a total face value that is less than its last round of bonds, which have reached their maturity date. Because outstanding bonds represent debt owed by the company, paying off $1 million in bonds and issuing only $500,000 worth of new bonds results in a lower debt load. The $1 million debt has been paid in full, and the new debt is only half the previous amount.
How Loan Paydowns Work
When a borrower pays more than the minimum required payment on a loan, the excess can be directed toward paying down the principal. This lowers the principal that remains due and also means less interest will accrue in the future. Even a single additional principal payment will reduce interest for the life of the loan.
Making extra principal payments toward a mortgage or other loan can shorten the length of the loan and reduce the total interest payments.
The Paydown Factor in Accounting
The term paydown is also used in accounting. The paydown factor is a way to assess the overall performance and risk level of financial products such as mortgage-backed securities or a portfolio of loans over time. In times of economic prosperity, borrowers tend to pay their debts at a steady pace. But in difficult times, more of them may become delinquent in their payments, a fact that will be reflected in a deteriorating paydown factor.
Example of a Consumer Paydown
A common example of a consumer paydown is making extra principal payments toward a mortgage.
Suppose a homeowner has 20 years of payments remaining on a $300,000, 30-year mortgage with an interest rate of 5%. Their normal monthly payment (principal and interest) will be about $1,610.
However, if they were to contribute an extra $100 a month toward principal, they'd save about $15,250 over the life of the loan and pay it off nearly two years sooner.
If they were able to pay even more than $100 extra each month, they'd save even more and pay off their mortgage even sooner.