The Financials Behind a Prepayment Penalty
Do you have a small business loan with a prepayment penalty? A prepayment penalty is a fee charged when you pay your business loan in full early. The lender doesn’t get all the interest they would have received if you had paid it off month by month, so they charge a prepayment penalty to recoup some of the profit they expected to earn.
Is paying off a loan with a prepayment penalty a smart decision? Here are some issues to consider.
What is the prepayment penalty? The penalty is calculated by multiplying your outstanding loan balance by a specified percentage (included in your loan documents).
What is your reason for paying off the loan? Perhaps your loan has a very high interest rate, and you want a lower-interest loan because interest rates have dropped, you have more collateral or your business’s financials have improved. Perhaps the loan has a balloon payment you want to avoid.
What type of prepayment penalty is it? Some loans have a straight prepayment penalty where you pay X% of the remaining balance. Others are on a sliding scale so the earlier you pay off the loan, the bigger the prepayment penalty. For instance, if you have a five-year loan, paying it off after one year might incur a 5% penalty; after four years, you might pay 1%. With this type of loan, you can save substantially by waiting to pay off the loan until you reach the next level of the scale.
Is paying off the loan the best use of your capital? Based on our experiences with personal debt, many of us dislike borrowing money and want to pay it back as fast as possible. But, both in business and in personal finance, there’s debt that hurts you and debt that helps you.
For example, in your personal life, too much credit card debt hurts your credit score. However, mortgage debt can be helpful since it enables you to pay for your home and establish an asset, often at lower cost than you would pay to rent a similar residence. Paying off your mortgage all at once might seem like a smart move, but could crimp your cash flow.
In the same way, paying off a business loan too fast could leave your business short of working capital now or in the future. Be sure you have a cushion to cover unexpected expenses or take advantage of unexpected opportunities.
Also consider whether the money you’d use to pay off the loan could be better used to invest in your business. Could it buy equipment, inventory, materials or commercial property that would help grow your business?
How will it affect your taxes? Interest on business loan payments is tax-deductible. When you pay off the loan, you’ll show more profits, increasing your tax liability.
How favorable are your loan terms? If your interest rate is low, there may be no reason to repay the loan early. If you’re paying exorbitant interest rates, paying off the loan early may save you money in the long run despite the prepayment penalty.
Will prepayment hurt your credit score? Paying off your loan early could actually lower your business credit score. Even with the prepayment penalty, lenders don’t make as much money as if you paid off the loan over time with all the interest. Therefore, they may report to credit agencies that the loan was paid, but in an unsatisfactory fashion. Talk to your lender about this.
Ultimately, the decision to pay off a loan with a prepayment penalty must be based on a cost-benefit analysis. What are the total costs, and is this the best use of your capital? Only you and your accountant can decide.
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