Definition
A prepayment clause is a provision within a bond or mortgage agreement that provides the borrower the option to repay the loan amount prior to the scheduled due date. This clause allows for the early settlement of the debt, which could be advantageous for the borrower under certain financial circumstances. However, some prepayment clauses might include penalties for early repayment, such as a fee or the waiver of interest that has yet to accrue.
Examples
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Mortgage Example: John takes a mortgage of $200,000 at a 5% interest rate for 30 years. After 15 years, John receives an inheritance and decides to pay off the remaining balance on his mortgage. His mortgage contract includes a prepayment clause, which allows him to do so. However, there is a prepayment penalty of 2% of the remaining loan balance.
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Bond Example: A corporation issues a bond with a maturity of 10 years but includes a prepayment clause that allows it to buy back (or call) the bond before maturity, subject to a call premium. This is beneficial to the corporation if interest rates decrease significantly, allowing them to refinance at a lower rate.
Frequently Asked Questions (FAQs)
What is the benefit of a prepayment clause to a borrower?
A prepayment clause enables the borrower to pay off their debt earlier than scheduled, which can save on interest costs over the life of the loan and help in debt management and financial planning.
Why might a lender include a prepayment penalty?
Lenders may include prepayment penalties to compensate for the loss of anticipated interest income and the administrative costs associated with processing the early repayment.
Are prepayment clauses common in all types of loans?
Prepayment clauses are more common in mortgage loans and bonds compared to other types of loans. However, their prevalence varies by market and specific terms of the borrowed funds.
How can a borrower know if their loan includes a prepayment clause?
The terms of the loan, including whether a prepayment clause and any penalties apply, will be detailed in the loan agreement documents provided at the time of the loan origination.
What is a ‘call feature’ in relation to a prepayment clause?
A call feature, similar to a prepayment clause, allows the issuer of a bond to redeem the outstanding debt before its maturity. It is an option for the issuer to repay the principal early, often at a premium to the bondholder.
Related Terms
- Call Feature: A provision in a bond that allows the issuer to repurchase and retire the bond at a specified price before the maturity date.
- Prepayment Penalty: A fee charged to the borrower for paying off a loan before its scheduled due date.
- Bond Call: The action taken by a bond issuer to redeem its bonds before maturity.
Online References
Suggested Books for Further Studies
- “The 30-Year Mortgage Swindle: How Your Mortgage is Robbing You, and What You Can Do About It” by Steve Dexter.
- “Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques” by Frank J. Fabozzi.
- “Fixed Income Analysis” by Barbara S. Petitt and Jerald E. Pinto.
Fundamentals of Prepayment Clauses: Finance Basics Quiz
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