5 Questions to Ask Before Paying Off a Small Business Loan Early
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Debt. For some, debt is a four-letter word. Nobody wants it, everyone’s working to get rid of it, but it seems unavoidable today. While paying off debt is a goal of many, doing so before the term is up might actually not be the best financial decision. If you’re thinking of paying off a small business loan early, be sure you’ve thoroughly considered the answers to the following questions.
1. Is There a Penalty for Paying Early?
From a lender’s perspective, a borrower paying off a small business loan early is not ideal, because it can mean they won’t get all of their interest. To discourage borrowers from paying early, some lenders will charge a prepayment fee. These fees can be structured many ways, but typically they are figured as a percentage of the balance left on the loan or a percentage of the loan total multiplied by the amount of time left in the term. In some cases, if the borrower has the cash to do so, it is worth it to pay this fee because of the savings on interest.
It’s worth noting that one of the most popular types of small business loans, the Small Business Administration (SBA)’s 7(a) loan, does charge a prepayment fee, but only if a loan with a maturity of 15+ years is prepaid during the first three years.
2. How Will Paying This Off Affect Your Taxes?
The interest paid on small business loans is tax-deductible. If you pay your loan off completely, you will lose that deduction at tax time. Determine whether paying the loan off is beneficial by asking your accountant if the money saved by the tax deduction is more or less than the interest you will pay through the duration of the loan.
3. What Is the Interest Rate and How Does It Compare to Those of Your Other Debt and Investment Options?
Even though your small business loan might be your largest debt, it’s not necessarily the one with the highest interest rate. Make sure you are aware of all your debts and their related interest rates and terms. For example, credit card debt traditionally has a very high interest rate, so it’s best to focus on paying that debt off first.
If you still have cash you’d like to use for prepaying a small business loan, take some time to research other forms of investment. You might be able to make that money work for you better by investing it in a CD or high-yield savings account that pays you more interest.
4. What Is Your Cash Flow Like and Do You Have an Emergency Fund?
Be realistic about your cash flow. Even though it will feel great to be free of your loan debt, will it put you in a tight spot when it comes to cash flow? If the answer is yes, it might not be worth the risk at this point. Additionally, consider whether you are truly prepared for an emergency. General wisdom warns you should have savings to cover your expenses for two to six months. If you don’t have money set aside for emergencies, it might be preferential to save your cash instead of using it to pay down your business loan.
5. Does This Loan Amortize?
In the beginning of an amortizing loan, most of your payments go toward the interest. As time goes on, more of each payment is applied to the principal. Paying off an amortizing loan early would save a business a lot of interest. Of note, SBA 7(a) loans are amortizing. However, if your loan has a fixed-fee structure, prepaying the loan does not afford you a savings, because you are forced to pay the interest for the full term of the loan.
There are a lot of moving parts to consider when deciding if prepaying your small business loan is the right choice. Take the time to do your research and consult with your accounting advisors to ensure paying your small business loan off early is the way to go for your company.