Prepayment

Prepayment refers to the act of paying an obligation before it becomes due or in advance of a scheduled payment. It commonly arises in lending and debt contracts, where borrowers may choose to make extra payments or pay off the loan early. Prepayment can reduce the total interest paid and shorten the loan term, but it may also trigger penalties or affect the borrower's incentive structure, depending on the terms of the agreement. Lenders and investors monitor prepayment risk—the possibility that borrowers will repay ahead of schedule, lowering expected interest income and altering cash flows.

In capital markets, prepayment risk is especially important for asset-backed securities such as mortgage-backed or consumer loan securitizations, because early repayment changes the timing and return of cash flows. Models such as the public security PSA are used to estimate prepayment rates.

In accounting, prepaid expenses are payments made in advance for goods or services to be received in the future. They are recorded as assets and expensed over the period benefited, for example prepaid rent or insurance. Properly accounting for prepayments affects both balance sheets and income statements.

Prepayment can also refer to the use of prepaid payment methods, such as cards or accounts funded before use. In all contexts, the financial implications depend on contract terms, interest rates, penalties, and regulatory treatment.