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Paydown definition

Paydown

A paydown reduces overall debt and can be implemented in several ways. For individuals, a paydown refers to gradually decreasing the underlying principal amount owed on loans by making monthly repayments. For corporations, a paydown could refer to issuing new corporate bonds worth less than the previous issue, thereby reducing the company’s debt load.

This article will explore some paydown examples to understand what paydown means.

What is paydown?

The objective of a paydown is to reduce the principal amount of a loan, which then lowers interest payments on the remaining debt. 

Overpayments on mortgage loans are one of the most common paydown examples. A mortgage is a long-term loan issued to buy a house, where the house and the land serve as collateral.

Let’s say Rachel wants to buy a home and takes out a mortgage of $150,000 over a 20-year term with regular monthly payments fixed at $1,000. If Rachel makes monthly payments of $1,100 – $100 above the required amount – the excess can be classed as a paydown because it helps reduce the principal amount. 

By doing this, Rachel not only reduces her principal by $100 every month, but she also reduces her interest payment and may be able to repay her loan early.

How does paydown work for corporations?

In business, a paydown refers to reducing a company’s debt load. A company can achieve this by issuing a new round of bonds with a lower face value than those of the previous issue that have now reached maturity

What is the paydown factor?

Paydown in accounting is tracked using the paydown factor, which indicates how much of a loan’s principal is being repaid with monthly loan payments. It is expressed as a percentage figure. 

How to calculate the paydown factor? Divide the amount you paid towards the principal this month by the original sum borrowed. 

The paydown factor can help evaluate the performance of financial assets such as mortgage-backed securities.

A mortgage-backed security, also known as an MBS, is a bond backed by a mortgage. Mortgage-backed securities are created by pooling together several mortgage loans, which are sold to government agencies and investment firms. The underlying mortgage loans act as collateral for the bond. Investors earn monthly interest by holding these mortgage-backed bonds.

The paydown factor is such an important metric in evaluating the health of the underlying loans in a mortgage-backed security that its publication is mandatory. 

An investor can evaluate the level of risk of the mortgage-backed security by looking at the paydown ratio. A decreasing paydown ratio could indicate the deteriorating financial health of homeowners who are struggling to make monthly mortgage repayments.

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