What Is a Paydown?
A paydown is a reduction in a company’s, government’s, or consumer’s overall debt. It’s common in business to issue a new round of corporate bonds at a lower price than the previous one. As a result, the company’s debt load is reduced. A paydown is when a consumer makes a greater payment on a mortgage, car loan, credit card, or any other type of debt in order to reduce the outstanding principal.
Understanding a Paydown
The purpose of a paydown is to reduce the amount owing on a debt’s principle. For example, a payment on an interest-only mortgage loan would not be considered a paydown. A payment on a credit card balance that does not exceed the regular monthly minimum payment plus the total of any additional purchases would not qualify. This is due to the fact that the debt’s principal is not reducing.
How Bond Paydowns Work
A paydown can be implemented by a firm or a municipal body issuing a fresh round of bonds with a total face value that is less than the previous round of bonds that have reached their maturity date. Because outstanding bonds indicate the company’s debt, paying down $1 million in bonds while only issuing $500,000 in new bonds reduces the debt load. The $1 million loan has been completely paid off, and the new debt is only half the size of the old one.
How Loan Paydowns Work
When a borrower makes a larger payment than the minimum necessary on a loan, the extra money can be used to pay down the debt. This reduces the amount of principal that is still owed, as well as the amount of interest that will be collected in the future. Even a single extra principal payment reduces interest over the loan’s term.
The Paydown Factor in Accounting
In accounting, the phrase “paydown” is also used. The paydown factor is a method of evaluating the total performance and risk level of financial instruments over time, such as mortgage-backed securities or a loan portfolio. Borrowers tend to pay their debts at a regular pace during periods of economic growth. In difficult circumstances, however, more of them may fall behind on their payments, which will be reflected in a decreasing paydown factor.
Example of a Consumer Paydown
Making extra principal payments toward a mortgage is a common example of a consumer paydown.
Assume a homeowner has 20 years of payments left on a $300,000, 30-year mortgage with a 5% interest rate. Their monthly payment will be around $1,610 (principal and interest).
If they put an extra $100 toward principal each month, they would save $15,250 over the life of the loan and pay it off nearly two years sooner.
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