What are Expedited Payments?
In the financial sector, accelerated payments are voluntary payments made by a borrower in order to reduce the unpaid balance of their loan more quickly. Depending on the terms of the loan, accelerated payments can be an attractive option for borrowers who wish to minimize their total cost of borrowing. However, some loan structures discourage accelerated payments by prepayment penalties and other such provisions.
Expedited payments are typically applied to the principal of a loan, reducing the outstanding balance and the interest required for future payments.
Key points to remember
- Expedited Payments are voluntary additional payments made on the principal balance of a loan.
- They are allowed in many types of term loans, such as home loans, but may be subject to limitations and fees.
- The attractiveness of accelerated payments will depend on a number of factors, including the interest rate on the loan and the opportunity cost of the borrower.
How expedited payments work
Expedited payments are a technique commonly used by borrowers in a variety of financial contexts. A common example is that of residential mortgages, in which borrowers are often allowed to make higher payments than mandatory payments in order to repay their principal more quickly. This, in turn, can lead to shortening amortization period and, therefore, a reduction of the set interest charges.
These accelerated payment structures are common in various non-revolving loans, also called term loans. These loans are structured according to a Amortization schedule, which defines the timing and amount of loan repayments. Each payment will have a component of interest and principal, with the percentage allocated to the principal gradually increasing as the loan matures.
Depending on the terms of the loan, the amount of interest contained in each installment may be based on either a fixed or one variable interest rate. The higher the interest rate on a loan, the more advantageous it can be to make accelerated payments. In fact, accelerated payments can benefit borrowers in two ways: In addition to lowering their interest charges, accelerated payments can also increase the rate at which the borrower accumulates equity in the financed property.
Overall, faster payments lead to faster principal repayment, which can lead to substantial interest savings.
Mortgages and accelerated payments
For example, in the case of a home mortgage loan, the borrower equity in the house gradually increases as the principal balance of the mortgage loan decreases. In addition to increasing the borrower’s equity, growing equity in a property can provide collateral to the borrower, which they can use to fund subsequent purchases. This equity can also be used to raise liquidity, for example through a mortgage refinancing operation.
While expedited payments can be beneficial, depending on the terms of the loan, it may not be economical to take advantage of this option. Some lenders include prepayment penalty clauses in their loan agreements, which limit or charge fees on accelerated payments beyond a specified limit.
In mortgages, this kind of prepayment terms is actually quite common. Lenders often limit accelerated payments to a maximum of 20% of the loan balance each year. Additionally, lenders may impose additional penalties if the borrower seeks to refinance the mortgage or sell the underlying property before the end of the mortgage term. For these reasons, it is important to carefully consider the legality of a loan to determine if expedited payments are truly economical.
Example of accelerated payments
Michaela is a real estate investor who recently bought her first rental property. Looking at the terms of her loan, she finds that her interest rate is 3.50% and that the terms of his mortgage allow accelerated payments of up to 20% of the outstanding principal balance each year.
When considering whether or not to make additional payments, she considers the pros and cons. On the one hand, making expedited payments would save her the equivalent of 3.50% annual interest on the amount of payments she chooses to make. In this sense, making accelerated payments is equivalent to investing in an asset that produces an annual return of 3.50%. Additionally, by making these payments, Michaela acknowledges that she will increase her equity in the rental property, thereby increasing the collateral she has to fund her next real estate purchase.
On the other hand, given the historically low interest rate on her loan, Michaela also realizes that she may be able to find a higher return on her capital elsewhere. For example, if she is able to raise funds from other lenders or investors in order to finance her next purchase, it might be better if she uses her capital as advance payment for a second real estate acquisition, potentially earning a return significantly higher than 3.50%.