While taking on debt in the form of a business loan might have been just what you needed to launch or expand your business, when you have the chance to pay your loan off early, you should, right?
There are a few more things to consider. Why do you want to pay it off? And will it cost you anything to do so? Could paying your loan off before it’s due actually put your business further behind financially? Simple questions… Not-so-simple answer. Here’s what you need to consider when you’re thinking about paying your loan off early.
If your loan has a big prepayment penalty, the cost of paying it off might outweigh the benefits of getting out of debt. A prepayment penalty, also known as a prepayment fee or even a prepayment incentive, helps lenders recover some or all of the interest they won’t get when borrowers pay loans off early. After all, they’re in the business of making money, and if you pay off the remainder of the loan before your term is up… Then they lose all the lovely interest payments they were planning for when they approved your loan.
That’s not to say it isn’t worthwhile paying a penalty to get out of a loan—it might be.
But is the penalty more than the remaining interest you would have to pay if you just kept making your regular payments? Once again, it might be.
Depending on the type of business loan and how far along you are in your term—the length of your loan—you might have paid all or most of your interest upfront. So paying off your loan not only won’t save you interest, your lender won’t lose out by you paying it off. While there might not be a penalty, there’s also no financial benefit for you to pay it off.
On the other hand, if you still owe interest and can pay off the remaining balance without penalty, you’ll save money.
Business loan prepayment penalties come in a few different flavors that can make a difference in how big your actual penalty will be. They include:
Lump-sum flat rate penalty
A flat rate penalty is an amount that represents a chunk of interest, like 3 months or 6 months. Ask for an amortization schedule so you can see how much you’ve paid off your balance and how much interest is getting paid off with each payment. If the terms of your loan include a flat rate penalty, you can calculate a rough estimation of what your penalty would be.
Percentage of remaining balance penalty
This one is even easier to figure out—here’s an example. A 40% prepayment penalty on $10,000 means you’ll pay $4,000—ouch—on top of your remaining balance to pay off your loan. Hey, I said it was easy—not painless.
If you’re a homeowner who’s paid off a mortgage early, you might be familiar with the reducing penalty. In this case, your prepayment penalty gets calculated on a sliding scale. The further you are into your loan term, the lower your penalty. These penalties are usually seen with longer-term, fixed-rate loans.
Short-term loan penalty
For short-term loans, the penalty works a little differently. Generally, these loans have higher interest rates and shorter terms than traditional loans. The loan agreement might state that there isn’t a prepayment penalty… But if you pay your loan off before your term is up, you also won’t be forgiven any of the interest, which effectively penalizes you for the early payoff. You pay the full interest amount whether you pay the loan off in 3 months or a year.
Once you evaluate your reasons for paying a loan off early and the prepayment costs that might come with that decision, think about what else you could do with that money if you didn’t pay your loan off early. Is this really the best use of your capital? Will it leave you short in case of a cash flow crunch or business emergency?
Also, consider the tax impact. While a prepayment charge on a business loan is tax-deductible according to the IRS, so is the interest you pay on the loan. Once it’s paid off, that tax deduction disappears.
For a handy at-a-glance table of the top alternative lenders and their prepayment penalties, check out this post on prepayment penalties.
There are some of us who just don’t like owing anyone money. If the thought of making loan payments keeps you up at night, it might be better for your mental health to simply pay off your loan. Just don’t forget about the financial cost to your business of doing so if there’s a penalty involved.
Has your credit improved since you first qualified for your current loan? Has your annual revenue gone up? Have you passed a significant milestone, like 2 years in business? If so, you might qualify for a loan at a significantly lower interest rate. And in this case, it could be possible to pay off your original, higher-interest-rate loan with the proceeds of a new, lower-interest-rate loan.
Depending on the prepayment penalty of the original loan and the difference between the two interest rates, you might come out ahead by doing so.
Before you take steps to pay off your remaining loan balance, read the terms of your loan. If the print is just too small or if the words and phrases leave you scratching your head, contact your lender and ask your loan officer:
1. What’s your prepayment penalty?
2. How much interest do you still owe?
3. And are there any other charges, costs, or fees to paying your loan off early?
When it comes to paying a business loan off early, here’s the bottom line: is the cost of prepayment worth the benefits to you? Will your business be further ahead financially if you do this? So remember, just because you can pay a loan off early doesn’t mean you should.