A prepayment is an early or advance payment of a loan. Many financial institutions allow borrowers to make these early repayments without penalty. Other institutions penalize the borrower because an early repayment lowers the lender’s return on investment and translates to unearned interest on the loan. In both scenarios, the loan documents or contracts specify whether or not there is a prepayment penalty. In many regions, there are laws against charging prepayment fees.
Many individuals use prepayment as a way to reduce interest costs or to reduce the length of a loan when other options are unavailable. Most people with poor credit are forced to finance at undesirable interest rates, and until a person’s credit score and credit history improve, he is unlikely to find a another lender offering a better rate. In order to save on interest costs and reduce his debt-to-income ratio, the borrower may make a prepayment, or several prepayments, on the current loan. This may improve the individual’s credit score and open up other options for better future financing in addition to reducing the individual’s overall financial burden.
Although some borrowers can afford to make a prepayment on a loan such as a mortgage, many do not realize the potential savings that results from a prepayment. There are two common ways that a prepayment can be calculated by the lender. The first allows the borrower to make a payment that directly-reduces the principal amount of the loan. For example, assume a borrower owes $500 US Dollars (USD) per month for his mortgage. The bank that financed his loan allows him to make an additional $100 USD prepayment per month, which would greatly reduce the amount of interest he would pay and time it would take to pay off the entire mortgage.
The second way that lenders allow borrowers to make prepayments pushes the due date back for the next payment. For example, if a borrower owes $500 USD per month for his mortgage and pays $1,000 USD in one month, the bank would extend the due date for his next payment an extra month because he prepaid the equivalent of another month’s payment. Assume his payments are due on the first of every month and the borrower pays $6,000 USD one month. The bank would extend the due date for his next payment an entire year.
Even when individuals can afford prepayment, many borrowers would rather keep the additional funds in a savings account. Others compare the interest rate on the loan and the interest rate on a Certificate of Deposit (CD) or other type of investment and decide that it is wiser to invest the funds than pay down the loan balance. Other borrowers, of course, simply cannot afford to make additional payments.