Prepayment Penalty: Definition and How to Avoid It

Advertiser Disclosure

What Is a Prepayment Penalty?

A prepayment penalty, also known as an early payoff penalty, is a fee you incur when 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 expressed as a percentage of your loan’s total remaining balance.

Although not all lenders charge prepayment penalties on business loans, it’s important to understand how these fees work, how to avoid them, and how to determine whether or not paying your loan off early is worth the potential penalty fee.

In this guide, you’ll find:

How Do Prepayment Penalties Work?

With this basic prepayment penalty definition in mind, let’s learn a little more about how these fees work.

If you’re wondering if your existing loan is subject to a prepayment penalty, you’ll want to look at your business loan agreement. If you are subject to this fee, you’ll find a prepayment penalty clause that details the specifics, including the timeline and how the fee is calculated.

Why Do Lenders Charge Prepayment Penalties?

If you’re wondering why prepayment penalties exist in the first place, the answer is simple: This fee ensures that your lender can recoup the interest they’re owed, even if you pay down your debt ahead of schedule.

Although it may seem like it would be advantageous for your lender to get their money back sooner, instead of waiting on monthly payments, this actually isn’t the case.

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.

In essence, small business loans either incentivize or disincentivize paying off loans early, depending on how they’re structured.

If your loan is amortized—a loan with a set schedule and compounding interest which you pay off via installments—and there’s no prepayment penalty, you’ll be forgiven your avoided interest if you pay down your debt early. On the other hand, if you have a non-amortizing loan, you won’t save any money on interest by paying early.

How Prepayment Penalties Are Calculated

It’s also important to understand that lenders can charge prepayment penalties in different ways. In general, there are three methods that small business lenders use to calculate these fees:

  • Percentage of loan balance: This is the most common way lenders calculate prepayment penalties. In this case, if you pay off a $50,000 balance early and the prepayment penalty is 5%, you’d owe an additional $2,500.
  • Lump-sum flat-rate: With this method, your fee is calculated based on how much interest you would have paid if you hadn’t paid the loan early. For example, you might have to pay a fee equal to three or six months’ worth of interest.
  • Reducing: The reducing method calculates your prepayment penalty based on how much of the loan you’ve already paid off. The more you’ve paid off, the smaller your fee.

Of course, if your business loan is subject to a prepayment penalty, the way this fee is calculated will be indicated in your loan agreement.

Prepayment Penalty Example

Now, let’s walk through a prepayment penalty example:

Let’s say you have a $300,000 loan with a five-year term. You manage to pay off your entire loan within the first three years of your term.

According to your loan agreement, you’ll face a prepayment penalty of 2% of the balance if your loan is paid in full within the first two or three years of the term. In this case, you’d owe a fee of $6,000 ($300,000 x 0.02).

Depending on your interest rate, this may have been the cheaper option for your business. However, if you knew you could have paid the loan off in only three years, you may have been able to avoid this $6,000 fee by opting for a loan with shorter terms.

Types of Prepayment Penalties

It’s important to keep in mind that most small business loans do not have prepayment penalty clauses.

However, some loans simply don’t incentivize prepayment, as amortized loans do. This means you’re not guaranteed to save money in the long run if you pay off your loan early, depending on what type of loan you have.

SBA Loan Prepayment Penalties

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.

In fact, both the SBA 7(a) and the SBA 504/CDC programs—two of the most popular SBA loan programs—have prepayment penalties.

Short-Term Loan Prepayment Penalty

Like most small business loans (other than SBA loans), short-term business loans don’t always come with a hard monetary prepayment penalty.

However, a “prepayment penalty” may be baked into the terms of the loan itself because short-term loans don’t amortize. Rather, short-term lenders might quote you a factor rate rather than an APR (annual percentage rate).

If you multiply your factor rate by the amount of capital you’re borrowing, 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 therefore, 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.

Personal Loan Prepayment Penalty

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.

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 this instance, there are actually several approaches you can take to both avoid a prepayment penalty and mitigate the situation—as well as potentially save you money on interest.

Partial Payment

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.

Fluctuating Penalties

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.

Questions to Ask Before You Prepay Your Loan

Other than freedom from daily or monthly loan bills, there are a variety 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 it off all at once can definitely affect your business’s finances overall. So, before you decide to prepay your loan, consider these questions:

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, it’s up to you to decide whether or not to prepay your loan.

To recap, you’ll only save money on interest by prepaying if your loan is amortized. If you have a non-amortizing loan, there’s no real benefit to paying early. Overall, 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 in the short and long term.

And—before you agree to any business loan, you should thoroughly review any documents and make sure that you understand the loan terms and repayment structure. If you have any questions, ask the lender or review the agreement with your business attorney.

See Your Business Loan Options

Caroline Goldstein

Caroline Goldstein is a contributing writer for Fundera.

Caroline is a freelance writer and editor, specializing in small business and finance. She has covered topics such as lending, credit cards, marketing, and starting a business for Fundera. Her work has appeared in JPMorgan Chase, Prevention, Refinery29, Bustle, Men’s Health, and more.

Read Full Author Bio