What Is a Prepayment?

A prepayment is the settlement of a debt or installment loan before its official due date. A prepayment is simply the payment of a bill, operating expense, or non-operating expense that settles an account before it becomes due. It might be made by a single individual, a corporation, or another type of organization.

Understanding Prepayment

Many types of debts and obligations can be settled in advance through prepayment. Corporations might prepay rent, wages, revolving lines of credit, or other short-term or long-term debt obligations. Consumers can prepay credit card charges before they actually receive a statement, or they might pay off loans early through refinancing.

Some loans, such as mortgages, assess a penalty for prepayment. Borrowers must be made aware of and agree to this provision at the time they take out the loan. The penalty typically only applies to paying off the entire balance, such as through refinance. You can usually make intermittent extra principal payments without penalty.

[Important: A prepayment might be made for the entire balance of the liability, or simply for an upcoming payment that's made in advance of the date by which the borrower is contractually obligated to pay.]

Example of Prepayment in a Corporate Setting

Prepayments are most commonly made in the form of prepaid expenses in the corporate environment. These expenditures are paid in full in one accounting period for an underlying asset that will be consumed in a future period. The prepayment is reclassified as a normal expense when the asset is actually used or consumed. A prepaid expense is first categorized as a current asset on the company's balance sheet.

For example, a company can list $6,000 as a current asset under the prepaid rent account on its balance sheet if it rents office space for $1,000 a 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 as an operating cost of $1,000 as the total prepaid rent expenses are actually incurred.

Key Takeaways

  • Many types of debts and obligations can be settled in advance through prepayment, but there's sometimes a financial penalty for doing this, particularly with mortgages.
  • Tax withholding from pay is a form of prepayment of taxes that will ultimately due.
  • Consumers can prepay credit card charges before they actually receive statements, often avoiding interest.

Example of Prepayment for Individuals

Private individuals can 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 she incurs $1,000 of total expenses on the card and pays it off on the 30th day of that month, it's considered a prepayment because the bill isn't actually due for another 30 days. The consumer's credit card company tracks these prepayments, so there's little need for the consumer to account for it personally.

Example of Prepayment in Taxation

Taxpayers regularly—and perhaps involuntarily—make a prepayment of taxes through withholding from their paychecks. Technically, taxes are due on or about April 15 each year, but employers are required to withhold taxes each pay period and send the money to the government on the employee's behalf.

Self-employed individuals are expected to make a prepayment of taxes by making quarterly estimated tax payments. In either case, the taxpayer will receive any excess back as a tax refund if he should pay more than his eventual tax liability.