Prepayment Penalties on Business Loans
Figuring out how much a loan will cost you isn’t as simple as multiplying an interest rate by how much you’ve borrowed. Different loans come with different terms and fees, including a potential prepayment penalty if you pay off the loan early. With any loan, find out all the details upfront before you sign on the dotted line. One idea to find out how much a prepayment penalty would cost is to ask a lender to quote you a similar loan with no prepayment penalty.
What is a prepayment penalty?
A prepayment penalty is a fee a lender charges if you pay off some or all of your loan early before the term of your loan is over. The penalty fee is typically a percentage of your total loan amount. Lenders charge the fee because interest is how most of them make a profit. So they try and protect their profits by ensuring that they’ll either receive all the interest they expect or they’ll get the money from prepayment penalties.
The good news is, prepayment penalties are most common in mortgages and car loans and not very common in small business loans. If the loan has one, however, make sure you know the exact amount or percentage of the prepayment penalty and that you won’t be charged any other fees if you end the loan early. All that information should be included in your loan estimate.
What types of loans carry prepayment penalties
The most common types of loans that have prepayment fees are mortgages, car loans and loans from the Small Business Administration (SBA), which are handled through most major lending institutions. These are all usually amortizing loans, meaning you’ll make monthly payments of principal and interest based on a schedule. The payments at the beginning of the schedule will be usually be more heavily weighted toward interest, with more money going toward the principal as time goes on. But most of the SBA loans only penalize you if you prepay in the first three years of the loan.
Some lenders will let you pay early on the portion of the loan not guaranteed by the SBA. The SBA typically guarantees between 50 to 90 percent of the loan so the unguaranteed portion could range from 10 to 50%.
SBA loans — The most common type of SBA loan is the SBA 7(a) loan. That’s a small business loan that offers up to $5 million in funding for expenses like expanding a business, refinancing debt or purchasing furniture, machinery and supplies. The SBA 7(a) loan has a prepayment penalty for loans with maturities over 15 years if they are prepaid within the first three years. The penalty is 5% at year one, 3% at year two and 1% at year three. Most of the SBA loans have the same terms. The SBA 504 loan, which is typically used to buy equipment or purchase or renovate property, also has a prepayment fee.
Personal loans — Some personal loans, which are based on your personal credit and a combination of personal and business income, come with prepayment penalties. So if you’ve taken out a personal loan to use for business purposes, make sure you know if you can pay off the loan early.
Merchant Cash Advances — With a merchant cash advance, a business owner will pay off a loan by giving the lender a percentage of future revenues whether it’s credit card sales or outstanding invoices. These types of loans are fast and easy to get, but typically come with higher fees and rates. The lender will also take the same cut of your sales regardless of how business was that day. Merchant cash advance fees are based on factor rates instead of interest rates. So you’ll have to pay off a fixed amount of fees and won’t be able to save interest by paying off the advance early.
What happens when you pay off your loan?
If you pay off a loan and your loan has a prepayment fee, you’ll have to pay that. If not, then you might start saving some interest, especially if your loan is amortized. If your loan has a factor rate, then you might not save money. You might also save yourself from having to pay a monthly or annual maintenance fee on the loan depending on when you prepay.
Paying off your loan, however, will mean you lose the ability to deduct the interest from your loans on your tax returns, said credit expert Gerri Detweiler, educator director at Nav, a company that helps business owners access funding and make informed financial decisions.
When does it make sense to prepay your loan?
It makes sense to pay off a loan early if the interest you’re paying is higher than what you can earn by using that money in other ways. For example, if you need the money for inventory or other ways to grow your business, it could hurt you.
The type of business you have matters, too. Interest costs will higher for a younger, smaller business than for a well-established business, so newer businesses generally have more to gain by paying off a loan early.
There are other fees to look out for, too. A line of credit rarely has prepayment penalties, but you might be charged an early termination fee if you want to close the line early. In this case, you may avoid the fees by keeping the line open and maintaining a zero balance.
It’s all about figuring out how much paying off a loan early will save you in potential fees and interest versus how what impact it will have on your business cash flow and taxes.
Paying off a loan early may not make sense if you have tight margins or could use the money for better, more profitable pursuits like investments or purchasing inventory. And of course, if paying off the loan doesn’t save you interest, or it comes with a steep prepayment penalty, that might make it a bad idea. But if you can safely afford to pay the outstanding balance on the loan, and it will save you a lot of interest, then it could be the right call.