Prepaying for goods and services is as old as mankind itself. If you want something, you must exchange a medium of currency in return. Often times, to reduce risk, companies will make you prepay for goods and services.
It is important to understand the principle of prepayment and what risks that opens you up to. In this post, we’ll explore the pros/cons of making a prepayment as well as tips and tricks you can use to keep your cash longer so that it can work for you.
Definition
Prepayment for goods or services means that cash is paid before the goods or services are provided. In this exchange, the seller of the goods or services is fully protected on the transaction while the buyer is open to quite a bit of risk.
For instance, what happens if you prepay for a bed set, but then that seller never provides those goods to you? In most cases, you have very little recourse once the money is out the door.
Keep in mind that prepay can come in many different forms; 100% prepayment, 50% upon start/50% upon completion, 25%/75%, etc.
If you think about it, we often times prepay for all of our smaller goods or services. For instance, you buy a meal and typically pay for it via a credit card. In larger transactions, while it is common to obtain financing, it is also common to provide “money down” to help push the transaction forward.
In many industries, prepayment serves as a ‘good faith’ payment that helps secure notice of a provider’s performance on an upcoming obligation. The more the prepayment, the more likely it is the company providing the good or service will perform.
However, one item I want consumers to focus on is how their power changes in relation to how much of a prepayment they provide.
As consumers, we buy and sell goods in a routine manner. A large majority of our smaller transactions are conducted on a cash or credit basis. We either:
- Give businesses our money in the form of cash,
- Pull out a credit card (aka ‘plastic’) and swipe bits and bytes for services.
The transactions, both minuscule forms of prepayment, are instantaneous enough that there is little-no risk to the consumer to pay in advance before we get the product. In a matter of minutes, we have the good.
However, what do we do when we run into higher-priced transactions that need to be financed over longer periods of time?
Enter the problematic issue of prepayment.
Whenever one is purchasing a good or service that has a large dollar value, expect to have the idea of prepayment (aka ‘money down’, ‘down payment’, etc.) on the table. As defined above, prepayment essentially boils down to paying for some, or all, of the good or service, before we receive the good or service.
There are various terms for a prepayment, such as:
- 25% down, the rest due upon signing
- 50% down, the rest due when the good arrives on site
- 100% down in advance of receiving a good or service
- 27%, 43%, 30%, etc.
The list could go on! The takeaway point the consumers is that companies can get really creative here. There is no limit to what they can do with their request for prepay funds.
So is prepaying always a bad thing? While we want to avoid prepaying as much as possible, there are times when it will be beneficial for us to do so.
The Advantages to Making a Prepayment
#1 – Secures goods and services.
With a reputable company, prepayment is not necessarily a bad thing. We can know that through our prepayment, we have secured a good or service and now it is up to the supplier to fulfill their end of the bargain.
Prepaying for the roofer helps him to know he can make the initial investment into sending his crew out to your location for the day. You can rest a bit better tonight knowing that the crew will arrive because the crew has been paid!
#2 – You might be able to secure discounts for prepaying.
Cash is certainly king. Any business wants to work with customers that will be willing to make a payment for goods and services quickly – even better is payment up front.
Often times, when you show the ability to pay well, the company will be willing to go to greater lengths to secure your business; this could mean favorable terms, discounts for early payment, and preferential treatment in the terms of great customer service.
By showing you have cash, you will win the ‘hearts’ of any business.
While there are certainly advantages to prepaying for goods and services, there are disadvantages as well. Enter thedark side of prepayments.
The Disadvantages to Making a Prepayment
In general, we want to avoid making prepayments for goods and services. By holding onto cash, we are in a stronger overall position. Below are the disadvantages to making prepayments:
#1 – You lose your negotiating power.
As consumers, we want to maintain as much negotiating and purchasing power as possible. When we prepay for goods and services, we lose this leverage, thus we lose our power in the relationship.
We are in a better position to negotiate terms when we are holding the cash to make the payment for the good or service. This offers us the benefit of saying to the company with which we are doing business, “once you deliver me a complete and satisfactory good or service, I will pay you money.”
In the example of holding the cash until the good or service is provided to a level in which we are satisfied, we own a high level of power.
However, when we prepay for the good or service, in particular when we prepay 100%, we are essentially reversing the power relationship to our supplier. In the majority of interactions, this will not be an issue.
But the risk inherent in prepaying funds is that the supplier might now provide a defective, incomplete, inferior, or otherwise unsatisfactory product. If you have already paid the supplier in full, you have very little recourse in terms of withholding payment until a satisfactory product is provided.
#2 – Your money is no longer working for you.
Companies that sell goods and services request prepayment for products for variety of reasons, the primary reason being they know that payment is in house, thus their risk of non-payment goes down drastically, as the individual now has ‘skin in the game’.
However, companies also like having prepay funds as those funds help to decrease their cash conversion cycle (CCC).
The CCC is the time it takes a company to convert a good or service into cash. Often times, the process will be something like this:
Manufacturing the good or securing the contract to provide the service ==> sell the good or perform the work ==> get paid.
Companies that can move ‘get paid’ to the beginning essentially are using customer funds to pay for the good or service. They don’t have to bear the entire weight of manufacturing costs, or in the case of providing a service, paying for the time of contractors.
While this is great for the company, it is not great for us as individuals or companies hiring the services.
As investors and Financial Freedom seekers, we need to be fully cognizant of the time value of money. When we prepay for a product, we are giving that supplier the use of our money for however long they are holding onto it.
What this means to us is that our money is no longer working for us. By handing over our cash, it is out of our interest-bearing savings account or it is out of the market where it could be making returns, or dividends, and otherwise helping us earn money while we sleep.
#3 – You run the risk of receiving defective or incomplete goods and services.
I am a generally optimistic person and believe that when we prepay our suppliers, they will deliver us a set of goods or services in a timely and satisfactory manner. However, I also adopt a risk-averse mindset which leads me to protect my downside in all circ*mstances.
The fact is, we need to be cognizant that there are some nefarious individuals and companies out there. Companies that would take our prepay money and never provide a service.
Worst case scenario: You could be dealing with the scam artist, whose main objective is getting a prepay, then not delivering the goods or services. He or she simply pockets the cash and never returns your call. Just look on review sites and you will find all sorts of allegations of this nature.
Best case scenario: You could hire someone who is simply incompetent. By prepaying for goods and services, they might deliver such an inferior quality product that it is almost like we have never received a product at all.
In both of these situations, we lose all of our power as consumers if we have given a full prepay for the goods and services. Sure, we can still leave negative reviews and report this transaction to the Better Business Bureau, but the idea of collecting our money once we have prepaid becomes a very challenging and ever.
It is often said that “Justice is Expensive“. That applies to situations like this; if we prepay $5,000 for a new roof and the contractor does not come through, it will often take more than $5,000 in court fees just to get to a judgment. In a situation like this, we would be out the $5k with a prohibitively expensive resolution cost.
So, when faced with the idea of prepaying for a good or service, what can we as Financial Freedom Seekers do? Here are some general tips and tricks for when dealing with a prepayment situation.
#1 – Remember that everything is negotiable
This may seem straightforward to most, however I find that a lot of people find the concept of negotiating for a good or service as something undesirable. While I admit that negotiations can sometimes be challenging, it is a necessary step in the process to receive our best value for products and goods we receive.
One thing to always keep in mind is that everything is negotiable. One of the benefits of living in a competitive marketplace is that if we want to have a good or service, there are many companies out there that would gladly take on our business.
For example, let’s look at installing a new roof. If you begin talks with one roofing company, and they want 100% prepay, you can solicit another bid from roofing company number two, that may require 25% prepay.
If you really want to use company one, you can then use this second-bid leverage to go back and negotiate them down to 25% or maybe even lower on their prepaid proposition. By engaging in this practice, you maintain the power in the negotiation relationship.
#2 – Do not prepay
The simplest solution is do not prepay. If the supplier does not agree to altering their prepayment policy to making it more consumer-friendly, then it is time to find other alternatives in the marketplace.
If you live in a capitalist society, this is easier to do. That is one of the reasons why I love capitalism. In fact, I wrote a poem titled “Ode to Capitalism” which you can find at RameySpace.com.
#3 – Make sure you are getting ‘paid’ for your time value of money
If you end up doing some sort of prepay, look to negotiate in a discount for the time value of money. If the company wants you to prepay for 50% up front, see if you can negotiate a 2% discount for taking the money out of the marketplace. This way you are at least being compensated for potential missed returns. Remember: we always want our money working for us.
Some companies will not entertain this but the point is to negotiate, negotiate, negotiate.
#4- Shorten up the duration of the prepayment
Typically, the duration for prepayments should not be very long as the longer the time frame, the more risk you open yourself up to.
When you are entertaining the idea of doing a prepayment, no matter what the percentage rate (i.e. 10%, 20%, 50%, etc.), delay making the prepayment until the last possible moment. This accomplishes a few victories:
- It maximizes the amount of time that your money is working for you in the market.
- It minimizes the amount of risk that your money is subjected to.
For instance, if you prepay a supplier a year in advance of delivery, a lot of negative events could happen within the year time frame. But if you prepay within the week, the chances of a large, negative event happening goes down significantly.
As a general rule, we do not want to prepay for any goods or services. This is not always possible, but keep the general rule in mind as this will help you retain your negotiating power in the transaction.
If you absolutely must prepay as a condition of doing business, then remember to minimize your downside and practice the tips and tricks presented within.
Good luck and happy negotiating!
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Disclaimer: (1) All the information above is not a recommendation for or against any investment vehicle or money management strategy. It should not be construed as advice and each individual that invests needs to take up any decision with the utmost care and diligence. Please seek the advice of a competent business professional before making any financial decision.
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