By Bradley Songer on November 8, 2010
 Prepayment is defined as repaying a loan by a borrower on an early basis. These loans are typically used on items like car loans and home mortgages where interest rates are low because the vehicle itself is expensive.
Anytime you borrow money from a lender an interest rate is applied. It is basically the fee to borrow money or assets from a lender. Many people choose to borrow money in order to buy products they need or want ‘now’ instead of ‘later’. Therefore, interest is the price paid for the use of borrowed money. Interest is typically paid to the lender as a percentage of the amount owed. Thus, 10% interest on $100 is $10. The percentage of the principal that is paid as a fee over a certain period of time (typically one month or year) is called the interest rate.
Interest is essentially the compensation that the lender receives for their risk of investment loss. Also, by allowing the borrower to temporarily borrow funds, they are forgoing other possible investments that could have been made with the loaned asset. This is also known as an opportunity cost. Instead of the lender using the assets directly, they are given to the borrower to utilize. The borrower then uses the borrowed assets to buy the products they require or desire ahead of time, while the lender is paid by the borrower the interest as compensation.
There are several types of interest available. A simple interest rate is used on loans with a single payment. Interest is calculated on the amount of the loan during the time period for which the money is borrowed. The effective rate is the same as the stated rate. It is interest that is calculated on a sum that does not include previous interest charges.
Compound interest means that each time interest is received on an interest bearing investment it is added to or compounded into the investment principal and thereafter also earns interest. For example, a bank deposit balance is estimated each day for daily compounding. Common compounding periods are daily, monthly, quarterly, annually and continuously. The more frequent the compounding period, the higher the effective rate of interest.
A fixed interest rate loan is a loan where the interest rate doesn't fluctuate during the fixed rate period of the loan. This allows the borrower to accurately predict their future payments. A floating interest rate, also known as a variable rate or adjustable rate, refers to any type of debt instrument, such as a loan, bond, mortgage, or credit that does not have a fixed rate of interest: instead, the interest rate may fluctuate with the prime rate.
For prepayment, for example, a 5-year loan for a $10,000 vehicle with a 3% interest rate is generally accepted as a low interest rate loan. Within 5 years, you would have to pay approximately $1,592.74. If you paid it off in, say, two years, the interest decreases to $609. Thus, prepayment is generally considered by lenders as a risk because the faster a borrower pays off the principle amount, the smaller amount of profit a lender will make. Refinancing also affects loans because the new financing may cause the interest rate to decrease due to the borrower’s credit rating being improved. Without incentive to loan out money, lenders will not lend money to a borrower. Therefore, to compensate for this, a prepayment penalty is sometimes included in the loan contract.
There are two types of prepayment terms: a soft prepayment and a hard prepayment plan. Soft prepayment plans generally allows one to prepay without penalty of selling off your asset, whether that be a car or a house or another product. A hard prepayment plan does not allow any exceptions without penalty. |