What is 'Prepayment'
A prepayment is the settlement of a debt or installment payment before its official due date. A prepayment can either be made for the entire balance of a liability or for an upcoming payment that is paid in advance of the date for which the borrower is contractually obligated to pay. Examples of prepayment include rent or early loan repayments.
BREAKING DOWN 'Prepayment'
A prepayment can be made by a single individual, a corporation or another type of organization. A prepayment, on the surface, is the payment of a bill, operating expense or non-operating expense that settles the account before it becomes due.
There are many types of debts and obligations that can be settled in advance through prepayment. Corporations can prepay rent, wages, revolving lines of credit and other short-term or long-term debt. Consumers can use prepayments on tax forms to settle future tax obligations, they can prepay credit card charges before they receive a statement, and sometimes they can prepay loans through refinancing. However, some loans, such as mortgages, sometimes assess a penalty for prepayment. Make sure that a prepayment is allowed without penalty prior to making one.
Prepayments in a Corporate Setting
In the corporate environment, prepayments most commonly come in the form of prepaid expenses. These expenses are expenditures that are paid in full in one accounting period for an underlying asset that will be consumed in a future period. When the asset is used or consumed, the prepayment is reclassified as a normal expense.
A prepaid expense is first categorized as a current asset on a company's balance sheet. If, for example, a company rents an office space for $1,000 a month and prepays six months of expenses, it lists $6,000 as a current asset under the prepaid rent account on its balance sheet. Each month, as $1,000 of the total prepaid rent expenses are actually incurred, the company reduces the current asset by $1,000 and lists the expense on its income statement as an operating cost.
Prepayments for Individuals
Private individuals can also make prepayments, and the personal accounting process is much easier. Using another example, consumers often 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 a credit card and pays it off on the 30th day of that month, even though the bill isn't due for 30 days, it is considered a prepayment. The consumer's credit card company tracks these prepayments, and there is little need to account for the prepayment personally.