The Pros and Cons of Paying Off a Short-Term Loan Early
When is paying off a business loan not a good thing?
When you’ve taken out a short-term loan, paying it back before the term is up is not necessarily a smart move. Here’s a closer look at the pros and cons of paying off a short-term loan early.
How a Short-Term Loan Works
A short-term business loan typically has a term of three to 18 months, with daily or weekly payments, explains Tom Sauer, VP of Customer Success at Fundera. “Suppose you take out a $100K loan with a $120K payback over one year,” Sauer says. “That is a 1.2 percent factor rate.” While this might seem at first glance like a 20 percent interest rate, Sauer says, “The daily payments accelerate the interest, so it’s more like 30 or 35 percent.” Many lenders won’t explain these details.
Why Pay Back a Short-Term Loan Early?
Paying a short-term loan off early frequently occurs when a business owner has paid back part of the loan and needs more money. “Suppose at the 6-month mark, you have paid $60K of that loan back, and owe $60K more,” Sauer says. When a different lender offers you $100K for an $115K payoff, “it sounds cheaper, so you go for it.”
What you may not realize is that the second lender will want to buy out your original loan before lending you that $100K. Otherwise, Lender 2 will be in a riskier position, behind Lender 1 in line for payments if your business runs into trouble or goes bankrupt. So what happens?
Where This Can Go Wrong
Lender 2 will use part of the $100K you’re borrowing to wire Lender 1 the $60K you still owe. However, there’s no forgiveness for the interest you owe on the daily payments—and since you’re moving up the timeline, that 30 or 35 percent interest rate skyrockets even higher. “Meanwhile, you now owe Lender 2 $115K, but you only have $40K in your account,” Sauer explains. “The cost of this money is huge!”
Unfortunately, Sauer says he sees many entrepreneurs become trapped in this type of situation. “The temptation to get that $40,000 into their accounts tomorrow is too overpowering to resist,” he says. “This is how small business owners can get into trouble.”
Understanding Your Margins
Of course, if you need to keep taking out short-term loans, there are bigger problems with your business than an infusion of capital can fix. Sauer emphasizes the importance of doing the necessary math upfront before applying for a loan. “Most business owners don’t really know their margins,” he says. As a result, most underestimate expenses and overestimate potential growth, when they should do the opposite. Understanding your margins ensures that deployment of short-term loan capital works the way it should—to help the business’s growth trajectory.
In addition to understanding your margins, Sauer advises businesses to negotiate for prepayment incentives or discounts—especially if you anticipate paying the loan off early. “A good lender will offer a prepayment incentive, such as 15 percent off the interest,” he says. Negotiating a weekly payment option, rather than daily, will also decrease the interest.
Other Things to Note
Finally, Sauer says, watch out for any type of last-minute changes in pricing or fees, and know how your commercial loan broker gets paid. Some brokers roll their fees into the amount you’re borrowing—which means you’re paying interest on the fee. No matter how eager you are, wait a few days before you sign on the dotted line. If the broker puts undue pressure on you, “that’s a red flag.”
Is Paying Off a Short-Term Loan Ever a Good Idea?
So is paying off a short-term loan early ever a good idea? Yes, Sauer says, but only if your business is growing and you are not in need of another short-term loan product. In the example above, he continues, “If you get a big job and can afford to pay off the $60K early, you’ll effectively increase your APR. But, again, that’s okay if you can afford it. Or do you leave the $60K in the bank, forget about it and let it draw down to zero [as you pay off the loan slowly]? Most business owners wouldn’t trust themselves to do that.” The peace of mind from eliminating daily payments can be worth the cost.
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