What are Prepayments?
Prepayment refers to obliging the quid pro quo in monetary or other terms agreed by both the parties where one party obliges the payment before the date when it is due or mandated by the terms, it may be an advance payment before the loan is to be paid or payment before the receipt of goods and services.
When one party pays to another party any amount before the services or goods are actually delivered or payment of any debt then it is known as prepayment. The amount does not have to be the full amount of the contract to qualify as prepayment; it can be a partial amount of debt or obligation. Depending on the nature of both the parties and the payment its nature shall change accordingly.
For a company payment shall be mostly for the prepaid expenses or in case of the bank it is mostly the amount already advanced received back etc. Prepayment can be used as a financial tool and if used correctly it can be of great help in furthering the cause of the organizations as well as individuals.
Examples of Prepayment
- Mr. Jerry has acquired a home loan from ABC Bank Limited for 15 years, the principal amount still outstanding is $ 2,500,000 and the interest rate per annum is 14%. Now he is offered by another bank the same amount of loan at a much lower interest rate of 10% which will enable him to save 4% annually on interest cost. If Mr. Jerry pays off the whole principal amount outstanding at ABC Bank then it will be regarded as a prepayment of debt.
- Amount paid for booking the auditorium in advance to hold its annual general meeting by an entity at a future date is another example of prepayment.
Types of Prepayment
Below are the types of prepayments which are as follows:
- When anything is paid as prepayment or in advance for any goods and services yet to be delivered or with respect to any money already advanced as loan and it is received before it is due. With respect to the amount received as an advance for any goods or services, it is considered as an asset in accounting terms because until the services are received or goods are delivered the money is now owed to the party making payment.
- When anything is received as prepayment or in advance for any goods and services yet to be delivered or with respect to any debt outstanding and it is received before it is due. With respect to the amount received as an advance for any goods or services, it is considered as a liability in accounting terms because until the services are received or goods are delivered the money is already owed to the party making the payment.
How to Manage Prepayments?
Managing the prepayments really depends on the many factors like availability of cash or assets to pay and either the conditions are favorable to pay in advance or it is mandatorily stipulated in the contract to pay a certain amount in advance. One must first possess the knowledge of the economic and political factors which directly affect the functioning, then all the alternative scenarios or alternative courses of action need to be considered for example whether making the prepayment of debt is actually going to reduce the overall cost of the firm or not. Achieving a predefined goal should be the objective here.
- Tax prepayments can be used to pay taxes in advance either by an individual or a corporate body and taxes can be either income tax or indirect taxes like sales tax to the government.
- Settle an individual liability like prepayment of personal expenses or credit card payment in advance.
- It is most commonly used by corporate as payment of expenses which either be goods or services apart from the debt which is considered as prepaid expenses and are part of assets until realized as expenses.
Penalties for Prepayment
Sometimes there is a prepayment clause in the contract or the terms of agreement whereas it is stipulated as to what shall be the modus operandi if payment is to be made in advance, it may further specify the penalty for making payment before the amount is due as it shall be considered that the other party is not adhering to the terms of the contract. Such penalties are most common in debt contracts when the lender is seeking early foreclosure of the loan account, they are a tool to discourage such payments as prepayment shall result in loss of business to the lender.
Advantages of Prepayment
Some of the advantages of prepayments are as follows.
- Ensuring the security of the payment and putting the onus to fulfill the contractual obligation on another party to the contract
- Prepayment may be beneficial when economic conditions are favoring the payment in advance of a loan and it can help save money for example prepayment of debt if the fixed-rate interest loan has now become expensive as the rates of interest lower down.
- Prepayment can help you save cost as sometimes payment made in advance actually gets you a good deal and the vendor may reduce its cost.
Disadvantages of Prepayment
Some of the disadvantages of prepayments are as follows.
- Ensuring the safety of the money paid can sometimes become difficult if prepayment is made as the other party to the contract may not perform its obligations at all or may just flee away, in that scenario he may become difficult to track down and the money may be lost.
- Prepayment can prove to be more costly if the penalties are levied in case of debt restructuring.
- Prepayment may not cause any benefit to the party making the payment in that case why someone would part with their assets.
A prepayment is a tool that must be used wisely and after considering all the social, economic and political factors involved. Sometimes it becomes necessary just to create new relationships and goodwill whereas sometimes the risk involved may be too much to entail a prepayment. Prudence should be the base of any activity regarding prepayment and expert advice can be taken regarding the same.
This has been a guide to what is prepayments and its definition. Here we discuss types, examples, and uses of prepayments along with advantages and disadvantages. You can learn more about financing from the following articles –