What Is a Prepayment Penalty?
A prepayment penalty is a fee you’ll have to pay in some cases if you pay back your loan ahead of the predetermined schedule. If the terms of your loan include a prepayment penalty clause, then you’ll be penalized if you pay off your debt early. Typically, a penalty fee is a percentage of your loan’s total remaining balance.
Being in debt is stressful. Even if the terms of your business loan are pretty good, it’s easy to feel exhausted by those daily, weekly, or monthly bills. And paying your loan off early can seem like a logical way to release the burden of those payments and free up your cash flow. However, if your loan has a prepayment penalty, you’ll want to think this through carefully to make sure the savings outweigh any fees you’ll be charged.
Essentially, a prepayment penalty ensures that the lender can recoup the interest they’re owed, even if a borrower pays down their debt ahead of schedule. So, prepayment penalty clauses in your business loan agreement will make it hard for you to save on avoided interest if you pay down your debt early.
Here’s the good news: For the most part, small business loans have no prepayment penalty clauses in their terms. However, that’s not to say you’ll always save money by paying down your business debt early, even if your loan doesn’t come with a penalty.
Long story short, the prepayment penalty can be one of the more confusing parts of taking on business debt. But whether a penalty is specifically outlined in the loan’s terms or it’s baked into the loan product itself, it’s crucial to understand what an early loan payoff will cost you.
In this guide, you’ll find:
- What is a prepayment penalty?
- Why do loans have prepayment penalties?
- Types of prepayment penalties.
- Prepayment penalty example.
- What to consider when prepaying your loan.
- How to avoid prepayment penalties.
What Is a Prepayment Penalty?
A prepayment penalty, also known as an early payoff penalty, is a fee you’ll have to pay if you pay back your loan ahead of the predetermined schedule. If the terms of your loan include a prepayment penalty clause, then you’ll be penalized if you pay off your debt early. Typically, a penalty fee is a percentage of your loan’s total remaining balance. It can also be expressed as a lump sum flat-rate penalty or what is known as a “reducing penalty”—where the penalty depends on how much of the loan you’ve already paid off. The more you’ve paid off, the smaller your fee.
Why Do Loans Have Prepayment Penalties
Even a simple prepayment penalty definition might sound a bit counterintuitive: Why wouldn’t your lender want their money back sooner, rather than waiting on those monthly payments?
Keep in mind that the money you’re repaying comes stacked with interest, and that interest is how lenders make a profit. So, if you decide to repay a loan six months early, your lender loses six months’ worth of interest on that loan balance. That loss is what a loan prepayment penalty is meant to mitigate.
Unlike mortgage and car loans, though, most small business loans have no prepayment penalty clauses in their terms. That said, prepaying your loan isn’t always guaranteed to save you money—even if it doesn’t include an official prepayment penalty clause in its terms. That’s because small business loans either incentivize or disincentivize paying loans early, depending on how they’re structured.
In other words, you’ll either save money on interest by paying early, or you won’t. It’s pretty simple, really. You just have to know whether your loan is amortized or not. An amortizing loan is a loan with a set schedule by which you’ll pay off your loan via installments. Take a look at your business loan’s repayment schedule—if it’s an amortized loan schedule and there’s no prepayment penalty clause, you’ll be forgiven your avoided interest if you pay down your debt early.
The Prepayment Penalty in Different Forms
Again, most small business loans have no prepayment penalty clause in their terms. However, some loans simply don’t incentivize prepayment, like amortized loans do—so you’re not guaranteed to save money in the long run if you pay off your loan early, depending on what type of loan it is.
In particular, it might not be worth prepaying the following types of loans:
SBA Loan Prepayment Penalty
Do SBA loans have prepayment penalties?
Although SBA loans are fully amortizing, these government-backed loans do outline specific prepayment penalties in their terms, which makes them an exception to the norm.
- If your loan term is less than 15 years, there’s no SBA loan prepayment penalty.
- If your loan term is 15 years or more, you’ll be hit with a penalty if you pay off your loan within the first three years.
- In that case, you’ll have to pay 5%, 3%, then 1% of the amount you prepaid, respectively, for three successive years.
Other types of SBA loans, including SBA 504/CDC loans, come with prepayment penalties attached, too. So, if you have an SBA loan—and you’re able to pay off that loan early—consult its terms to know exactly how your SBA loan prepayment penalty works (and whether your business can manage that extra fee).
Short-Term Loan Prepayment Penalty
Like most small business loans (other than SBA loans), short-term loans won’t come with a hard monetary prepayment penalty. But a “prepayment penalty” may be baked into the terms of the loan itself.
That’s because short-term loans don’t amortize. Rather, short-term lenders might quote you a factor rate rather than an APR (which is an annualized indication of a loan’s total cost). Multiply your factor rate by the amount of capital you’re borrowing, and that’s the total amount you owe the lender. Factor rates charge interest to the principal from the get-go—so interest doesn’t accrue over time, as is the case with amortized loans.
So, you’ll always need to repay that fixed amount, regardless of how quickly you repay—and you won’t be saving any interest if you decide to get out of that loan early.
Merchant Cash Advance Prepayment Penalty
Through merchant cash advances, a financing company advances you a certain amount of capital, and you’ll repay that finance provider by letting them cut into a fixed percentage of your daily credit card sales, plus additional fees. MCAs are an option if you’re in serious need of fast cash because they’re fairly easy to qualify for, and you can get that advance in a day or two.
Like short-term lenders, MCA providers determine their fees with factor rates, rather than interest rates. Because you’re tied to a fixed amount of fees, you can’t save on interest by paying off your MCA early. So, even though you won’t see an explicit early repayment penalty clause in a merchant cash advance agreement, you nevertheless won’t be able to save by paying down your debt early.
Certain personal loans come with a prepayment penalty—although it’s not that common. With a personal loan prepayment penalty, the lender will typically charge you a percentage of the loan amount as a penalty for prepayment. If you pay off your loan quickly, it might be cheaper than the interest you would otherwise be charged. But the longer you have the loan, the less incentive you have to prepay.
This is something to keep in mind if you’re considering using a personal loan for business purposes.
Additional Prepayment Penalty Considerations
Another thing to keep in mind with prepayment penalties is that they can vary among lenders. Therefore, borrowers should be proactive in asking about an early repayment penalty before agreeing to a loan. We also recommend having a business attorney look over your loan agreement before signing.
Prepayment Penalty Example
To help you fully understand prepayment penalties, let’s provide an example. Say you have a $300,000 SBA 7(a) loan on a 20-year term. Somehow (and for whatever reason), you manage to pay off your entire loan within the first three years of your term. The first year you pay back $150,000, the second year you pay back $100,000, and the third year you pay back $50,000. Based on these amounts, you’ll have to pay back $7,500 the next year, $3,000 the year after that, and $500 the year after that. That adds up to a total prepayment penalty of $11,000.
Depending on your interest rate, this may have been the cheaper option for your business. However, generally speaking, paying back a 20-year term loan within the first three years sort of defeats the purpose of the loan.
Before You Prepay Your Loan, Ask Yourself These 6 Questions
Other than freedom from daily or monthly loan bills, there are lots of reasons why you might want to prepay your small business loan. Whether you want to get out of a bad loan, refinance your business loan, or simply save on avoided interest, you should certainly weigh the decision of paying down your debt early carefully.
Even when prepaying your loan saves you money in the long run, paying off that much money all at once can definitely affect your business’s finances overall. So, before you decide to prepay your loan, consider these six questions:
1. What’s My Loan Amortization Schedule?
As a reminder, you’ll pretty much only save by prepaying your loan if that loan amortizes. If that’s the case, check your loan’s amortization schedule. That way, you’ll understand where, in the life of your loan, your lender stacks the principal versus the interest. Paying down your loan early may or may not save you as much on interest as you think.
2. How Will Prepaying My Loan Affect My Cash Flow?
Although a loan might cut into your cash flow on a daily, weekly, or monthly basis, prepaying the entire balance of that loan at once would take out a big chunk now. So, it may feel good to get those loan payments out of the way ahead of time, but your business may not be able to withstand that loss in working capital.
3. Is Prepaying My Loan the Best Use of My Money?
It may be tempting to use the cash earned from a windfall or a high season to get out from under your debt early. But consider whether prepaying your loan is the best use of that cash. Maybe you could invest in new equipment, inventory, or marketing. Or maybe it’s best for your business to keep that cash on hand as a cushion during future slow seasons. What’s important is that you don’t get tunnel vision: Just because you can prepay a loan, doesn’t always mean you should.
4. How Will Prepaying My Loan Affect My Taxes?
You can declare the interest on your business loan payments as a deductible on your tax returns. In fact, you can deduct the interest you pay on any kind of loan if you’re using that money toward your business. (But you have to really use that money—any interest you pay on the money in your business bank account isn’t a deductible business expense.) So, if you pay off your loan early, then you’ll lose a portion of that deductible with the interest you avoid paying.
“We caution our clients to seek the advice of a competent accountant who may be able to classify your prepayment penalty as early interest repayment, allowing you to itemize the interest as a possible tax deduction,” says Jim Angleton a financial planner and president of Aegis FinServ Corp.
5. Can I Refinance My Loan and Get a Lower Rate?
“We see many clients get stuck with bad loans that have high interest rates,” says Angleton. “In this situation, it is wise to refinance, even if it means taking the hit on the prepayment penalty.”
6. Am I Selling My Business?
One last reason you may decide to prepay, even if it means taking a prepayment penalty, is if you have decided to walk away from your business. In this scenario, you may just want to rid yourself of all business debt as quickly as possible—and the proceeds from the sale of your business can go toward paying off your remaining debt.
How to Avoid a Prepayment Penalty
Say you have a loan with a prepayment penalty, and you don’t want to wait to pay it off. In that situation, there are actually several approaches you can take that will save you money on interest.
Some lenders allow for partial payments. This means you can prepay a portion of your loan every year without facing penalties. For example, depending on your loan, you may be able to pay 25% of your loan balance in one payment.
Some loan agreements come with fluctuating prepayment penalties. For instance, after a certain amount of time, the prepayment penalty might go down or disappear entirely. This allows you to pay off the remaining balance quickly, rather than having to pay off the balance plus interest over several more years.
The Bottom Line
With the exception of SBA loans, most small business loans have no prepayment penalty clause in their terms—unlike mortgages or car loans, which often do. So, without a hard monetary fee, deciding to prepay your loan or not is a matter of financial incentive. Depending on how your loan’s repayment terms are structured, you might save on interest. Or, you might not. It really depends on whether your loan is amortizing or not.
If your loan amortizes, then you can save months’ worth of interest if you pay before the term is up. (Medium-term loans and equipment loans most likely amortize.)
But if your lender quotes a factor rate, then there’s really no financial incentive for you to prepay. That’s because you’re agreeing to repay a fixed amount within a certain timeframe, and your loan bills don’t accrue interest. So, it doesn’t matter whether you pay that total amount now or later—it’s not going to change, so you’re not going to save any money by paying now.
Even if you do have the means and desire to pay off your loan early, it’s in your best interest to think about how prepaying will affect your business’s finances overall. Paying off that huge amount now, for instance, will cut into your cash flow more dramatically than monthly loan bills will. Or, you might contribute that surplus of cash toward another worthy cause, like investing in new equipment, covering payroll, or giving yourself a safety net in case your business hits a rough patch.
Before you agree to any loan, check its exact terms and repayment structure. It’s always a good idea to know exactly what you’re getting yourself into—or, eventually, getting yourself out of.