What is Prepayment?
Prepayment is an accounting term for the settlement of a debt or installment loan in advance of its official due date. A prepayment may involve the settlement of a bill, an operating expense, or a non-operating expense, effectively closing an account before it’s due. Prepayments can be executed by individuals, corporations, or other organizations.
Understanding Prepayment
Various types of debts and obligations are often settled early through prepayment. Corporations may prepay rent, wages, revolving lines of credit, or other short-term and long-term debt obligations.
Consumers have similar opportunities to prepay credit card charges before receiving a statement or by paying off a loan early. This can be accomplished through refinancing the debt with another lender or paying the entire debt out of pocket.
Some loans, like mortgages, might include prepayment penalties. Borrowers must be made aware of and agree to these provisions when the loan is taken out. The penalty typically applies to paying off the entire balance, usually by refinancing the mortgage. However, a borrower can often make intermittent extra payments on the principal without penalty. A prepayment might cover the entire balance of a liability or be a partial payment made in advance of the due date.
Types of Prepayment
Prepayments occur commonly in various contexts, involving both individuals and large businesses.
Corporate Prepayments
In corporate settings, expenses are the most common type of prepayments. These expenditures are paid in full in one accounting period for goods or services that will be utilized in a future period. The prepayment is reclassified as a normal expense once the asset is used or consumed. Initially, a prepaid expense is recorded as a current asset on the company’s balance sheet.
For example, if a company rents office space for $1,000 a month and prepays six months’ rent, it can list $6,000 as a current asset under the prepaid rent account on its balance sheet. Each following month, the company would reduce the current asset by $1,000 and list the expense on its income statement as an operating cost of $1,000 as the prepaid rent expenses are incurred.
Individual Prepayments
Individuals also make prepayments, and their personal accounting process is considerably simpler. A consumer might accumulate a monthly credit card bill with a settlement date of 30 days after the month ends. If the consumer 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 due for another 30 days. Credit card companies track these prepayments, so consumers usually don’t need to account for it personally.
Prepayments by Taxpayers
Taxpayers regularly make prepayments of taxes, either voluntarily or as a requirement when part of their income is withheld for taxes. Although taxes are technically due around April 15 each year, employers are required to withhold tax from each pay period and send the money to the government on the employee’s behalf. Self-employed individuals, on the other hand, are expected to prepay their taxes by filing quarterly estimated tax payments. In either case, if taxpayers pay more than their due taxes for the year, they receive any excess as a tax refund.
Related Terms: debt management, expense management, prepaid expenses.
