Prepayment: Definition, How It Works, Types, and Penalties


In financial modeling, it’s important to have a clearly modeled debt schedule. The basic starting assumption is that all debts will be repaid when they are due. In order to determine when debts are due to be paid, an analyst can look in the notes to a company’s financial statements. If, however, there is a reason to believe the debts will be repaid early, the analyst should build that into the financial model and the resulting cash flow.

Examples would include one-off transactions for individual
contracts, refundable deposits, construction works and long-term agreements (LTAs) for health products. A prepayment is a financial tool by people who intend to make the most out of a payment obligation. For instance, an insurer may choose to prepay the insurance premium, which will become due next year, or a firm may prepay its supplier well before receiving the consignment. For example, you pay your rent in January to cover the next six months ( January to June). Instead of recording single lump sum in January , you spread the cost across each month. If you receive an invoice or make a payment that covers several months, and you record it as a lump sum in one month, this can affect your profit for that month.

Partial Prepayments

A prepayment may be the settlement of a bill, an operating expense, or a non-operating expense that closes an account before its due date. A prepayment may be made by an individual, a corporation, or any other type of organization. So, it can be seen that prepayment is a very useful tool that both corporates and individuals can use to reduce their financial burden and get monetary benefits. While the corporates need to take care of the accounting process, individuals don’t need to worry about accounting. As another example, a snow plowing company receives a $10,000 advance payment from a customer in exchange for plowing its parking lot in each of the next four months. The plowing company initially records the receipt as a liability, and then ratably shifts the amount into a revenue account at the rate of $2,500 per month in each of the next four months.

Here the individuals make the advance payment, and the accounting process, in this case, is much easier. Examples of prepaid expenses include utility bills, loan installments, credit card bills, etc. ABC Inc. paid $24,000 in advance for the marketing and advertising service offered throughout the year. The company will initially charge the entire $24,000 to the prepaid expenses account on the balance sheet.

How to account for prepayments

In his fourth year of repayment, John will pay $17,522 or 14% of the total interest amount. In his last year of repayment, John will pay $6,571 or 5% of the total interest. Let us look at the following examples to understand the concept of prepayment.

What is an example of a prepayment?

Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc.

First, an invoice is generated, then sent for payment, and then the payment occurs after the buyer receives the order. However, in some cases, the payment is made up-front in full well before receiving the goods or services. In such a scenario, the payment received by the supplier is known as prepayment. Prepayment is an accounting term for the settlement of a debt or installment loan in advance of its official due date.

Applications in financial modeling

This where you are billed for something at the end of a quarter and want to spread the cost across each month. Prepayments In the following steps, we’ll use the example that you pay for your electricity every three months in arrears.

John will have to pay $42,086 or 33% of the total interest in his first year of repayment. In his second year, John will pay $35,084 or 27% of the total interest amount. In his third year of repayment, John will pay $26,956 or 21% of the total interest amount.

Further guidance regarding prepayments can be found in the UNDP Programme and Operations Policies and
Procedures (POPP) on Prepayments. In other instances, banks may charge a specific portion of the loan amount as interest in the case of prepayment. Prepayments are used by individuals, corporations, and governments to settle accounts before they are due.


Some of the most common prepayment examples are loan repayment, prepaid bills, salary, rent, insurance premium, income tax, sales tax, credit card bill, line of credit, etc. As you post each monthly journal, a debit value posts to the relevant overhead nominal ledger account, in this example gas and electric, 7200, which appears on your profit and loss. The credit value posts to the accruals nominal ledger account and this appears on your balance sheet as the accrual is a current liability. At the end of the accrual period, you need to reverse the effect of these postings from your accounts.

How does prepayment work?

However, some types of goods or services require up-front payment in full before the goods or services are provided. In the traditional sales process, goods or services are ordered and fulfilled. An invoice is then sent for payment, meaning the payment occurs after the order is completed to ensure the goods are sent or are as expected. The penalty may only apply to paying off the entire balance, generally by refinancing the mortgage. A borrower can usually make intermittent extra payments of the principal without penalty.


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