Thursday, November 19, 2015

Prepayment Penalty: What Happens When You Pay Early?

Well, well, well. Looks like you made a great decision to take out that loan for expanding your small business. Whatever it was for—a new pizza oven, an experimental robo-employee—really paid off, and you’re rolling in dough. (Literally, if you got that pizza oven.)

But you’ve still got those pesky payments on your loan…They cut into your cash flow, and who likes the feeling of being in debt? So you might as well just use your newfound wealth to pay off your lender early, and not worry about it anymore, right?

Slow down there, cowboy.

Ever heard of a prepayment penalty? No? Then buckle up, because this’ll be a wild ride.

Prepayment What?

A prepayment penalty is pretty much just what it sounds like. If the terms of that loan you took out include a prepayment clause, then you’ll get penalized if you pay your loan off early.

This might sound a bit counterintuitive…Why would your lender want you to pay for the entire term of the loan? Wouldn’t they want your money now, if you’ve got it?

Well, it’s important to remember that the money you’re paying back comes stacked with interest—that’s how the lenders make a profit off you borrowing money. So if you decide to pay a loan back 6 months early, they lose 6 months worth of interest on that loan, and make less than they expected.  

For you, great. For them, not so much.

So really, a prepayment penalty is typically just a way your lender ensures they’ll get paid, too—even if that means taking it slow.  

Plenty of lenders and loan products don’t come with prepayment penalties, but it’s worth asking about before you sign that dotted line. An unexpected prepayment penalty can complicate your plans to get fancy with your financing—which we’ll discuss in a bit.

But first: what types of loans generally have a prepayment penalty, and what kinds of prepayment penalties are there?

It’s Not You, Loan—It’s Me

Breaking up with your loan can be tough.

By “breaking up,” we mean paying your loan off early. And by “be tough,” we mean it might have a prepayment penalty you weren’t aware of. That’s just how we think about these things.

How can you know if your loan has a prepayment penalty before you make the big break, though?

Well, the most important step is to check the terms of the loan. Ideally you’d have done this before you accepted those terms—but if not, you should go take a look, and ask your bank or lender directly to make sure you understand them right.

Other than that, we can work a bit off probability.

Door #1

For instance, the loan type most likely to have a prepayment penalty is the traditional term loan

This makes sense if you think about it. A traditional term loan is your run-of-the-mill business loan. Fixed money borrowed, fixed interest rate, fixed payback term…Except for long-term business bank loans and non-business loans (like house mortgages), term loans have just about the longest repayment terms you can get for your business. No wonder your lender wants to secure their payoff—they’ve been waiting so long!

Door #2

Speaking of long terms, you might be glad to hear that the Small Business Administration’s ever-popular 7(a) Loan Program precludes any participating lenders from charging a prepayment penalty.

Actually, there’s one exception: if your loan has a maturity of 15 years, but you pay it off within the first 3. In that case, you’d be cutting a substantial portion of the lender’s expected interest payments away, and the SBA doesn’t want to disincentivize lenders from working with it, too.

You can learn more about SBA loans here, by the way.

Door #3

On the opposite side of the spectrum, short-term loans also likely won’t have a hard monetary prepayment penalty—though a lender may not forgive your interest, increasing the APR of your total loan. That was a complicated sentence, but never fear: we’ll break it down in the next section.   

The Prepayment Penalty Emporium

So you’ve got a prepayment penalty on your loan…Does that mean you should just wait it out?

No! Never give up on prepayment!

Or…Maybe give up. Actually, it depends on what kind of prepayment penalty you’re looking at.

The Flat Rate

Some lenders use a flat rate prepayment penalty, which tries to stop you from prepaying by forcing you to pay a lump sum if you do.

This is the simplest prepayment penalty to understand, as it’s calculated based on the terms of your loan. While occasionally a lender might just charge a set fee, more often they’ll calculate the size of the penalty relative to your loan’s terms. For example, a prepayment penalty for a 3-year loan could be 6 months’ interest. These are also sometimes called prepayment fees—but it’s the same idea.

Seeing a solid—and potentially large—number to be taken out of your bank account if you prepay could be an intimidating moment. But thankfully, this type of prepayment penalty is also usually the easiest one to weigh the pros and cons of, since there are just fewer calculations you need to make. Will you still save enough, prepayment penalty and all? Will the prepayment penalty cut too far into your cash flow to make it worthwhile? Don’t get deterred by the presence of a prepayment penalty—you could save a lot of cash by managing your loan payment schedules the right way.

The Straightforward Penalty

Your loan might have a straightforward prepayment penalty clause that would cost you a certain percentage of your remaining interest balance, no matter what. This also makes it easy to see just how much you gain (or lose) by paying early.

Think of it this way. You want to pay off your whole loan now so that, in the next couple months, you don’t have to worry about weekly payments and cash flow flubs. You can use that extra weekly capital to do whatever—stock up on some extra perishable inventory, charge that robo-employee, get relaxing Friday afternoon mimosas—without worrying about making your payments.

But it might be that, depending on your prepayment penalty, you won’t have nearly as much extra cash as you thought. And by dishing out all that dough in one lump sum, you might have to skimp instead of spending or saving. No mimosas for you.

It’s also important to consider your loan’s amortization schedule. We’ll discuss this a bit later on, but briefly, most term loans are frontloaded with interest payments and backloaded with principal payments. As a result, if you’re prepaying late in the game, you’re not really saving much on forgiven interest—since you’re paying mostly the money you borrowed, anyway. The earlier you prepay, the more interest you save on.

While we call this a prepayment penalty, others may not. Some lenders let you prepay whenever you want, and forgive all the interest they’d lose in exchange for having your cash on hand instead of waiting around—and we take that stance as the baseline. If you’re paying more than you “should” based on how early you prepay, we call that a prepayment penalty.

But a lender could definitely call this a prepayment credit instead—because, they argue, you’re being credited some of the remaining interest by paying off your loan early.

It’s a matter of perspective, really. But whatever you call it, a prepayment clause in your loan’s terms should affect your decision whether and when to clear your debt up ahead of schedule.

The Sliding Scale Penalty

On the other hand, maybe your loan comes with a sliding scale prepayment penalty. It sounds intimidating, but really, sliding scales aren’t that scary. (Nobody dressed up as a sliding scale for Halloween, did they?)

Instead of a flat percentage rate of your remaining interest, a sliding scale prepayment penalty imposes a bigger penalty the earlier you pay off your loan. We mentioned this in another article way back when, but we’ll recycle the example. Say you have a five-year loan: you might incur a 5% penalty if you repay after one year, but a 1% penalty if you repay after four years. The longer you wait to repay, the better the repayment terms for you and the more interest paid for the lender.

If the timing of your repayment works out, then a sliding scale prepayment penalty can be win-win. And waiting a few weeks, or even a month, could make a big difference. If not, then you might get a worse deal than if you had the simpler prepayment penalty model. In either case, don’t lose sight of the fact that your loan might also come with the same amortization issue we just discussed—so you might save on the sliding scale by paying later but lose on the amortization payments.

Either way, make sure you know what prepayment penalty type your loan comes with—one of these, a different kind altogether, or none at all—so it doesn’t sneak up on you in the future.

The Short-Term Loan

A prepayment penalty on a short-term loan usually requires that you prepay a percentage of your entire remaining balance, rather than of the leftover interest.

Maybe this sounds unfair, but it’s for a sensible reason. Short-term loans don’t amortize, so you can’t know whether what you’re paying is the principal or the interest—in other words, it can be harder to figure out exactly when you need to prepay in order to save the most money.

But wait, what were we talking about before? With the short-term loans and the prepayment penalty and the APR?

To remind you, we said that “short-term loans also likely won’t have a hard monetary prepayment penalty—though a lender may not forgive your payback, increasing the APR of your total loan.” This phenomenon actually happens with every prepayment penalty, but it’s most obvious with a short-term loan because of its… Well, short term.

You might know already that APR is the Annual Percentage Rate of your loan, or the amount you’ll pay annually for the money you’ve borrowed. Simply put, it’s the loan’s interest rate plus additional fees. We don’t need to get into the mathematical specifics of the formulas you can use to figure it out, but a loan’s APR is tied to its repayment period and its interest rate.

So, say you decide to pay off a loan early, but there’s a prepayment penalty: the lender won’t forgive your interest. You’re basically shortening the repayment period of the loan while keeping its interest rate—which makes the APR rise.

Let’s look at a concrete example. Your one-year loan of $1,000 has an interest rate of 10%, so after a year, you’ll have paid your lender back $1,100. If there aren’t any origination fees, underwriting costs, and other expenses your lender might include, then your APR is also 10%.

But if you take the prepayment penalty and end the loan after 6 months, then you’re paying $1,100 after only half a year. Since APR calculates for a whole year, it would jump up to 20%!

Now, this doesn’t actually impact what you have to pay your lender, or your credit score—so does it matter at all?

It can go either way. You could decide that the APR hike is just a superficial increase, since you’re paying what you would have paid whether or not you settled the loan early. There’s no real tangible difference, so you can disregard it if you really want.

But alternatively, if we dig a little deeper into what APRs are supposed to do, you could also decide that this APR jump reflects the penalty part of prepayment penalty.

Ideally, you can standardize all your loan options according to their true APRs, comparing genuine apples to apples instead of interest rates to factor rates, with all sorts of hidden fees jumbled up. By raising the APR so dramatically because you decided to prepay your loan, a lender is messing up the standard metric of what loans actually cost you, the borrower.

In short: for the cost of a loan with the increased, post-prepayment penalty APR, you could’ve gotten a much better deal. That’s why we consider these to be prepayment penalties, even if they’re called prepayment credits or prepayment incentives. But on the other hand, if a lender doesn’t have a prepayment penalty, they are forgiving you of some of your promised payment.

Check the Rolodex

Before we talk more about deciding whether to take the prepayment penalty or not, let’s run through some of the industry’s top lenders and see where they stand.


*In some cases, eLease doesn’t enforce a prepayment penalty. In others, they include a prepayment penalty only if you prepay within the first year of the loan. Make sure to clarify your terms, if you borrow from them.

In our breakdown, Flat Rate refers to a flat rate prepayment penalty, while Penalty can refer either to the straightforward prepayment penalty or the sliding scale prepayment penalty. Some lenders may call these incentives or credit, but as discussed above, we don’t necessarily agree.

Whether you take a loan through one of these lenders or not, quadruple-check your terms. That’s just best practices, of course, but make sure to add “prepayment penalties” to your list of things to look out for.

So What’s the Move?

The piece de resistance: How can you tell whether a prepayment penalty is worth it?

Sadly, it’s not as easy as comparing numbers in the “for” and “against” columns and seeing where you’d save more. You have to think about why you want to prepay, and whether the prepayment penalty would satisfy that why. Consider your small business and its financial needs: it’s not just a matter of spending less, but also of when you spend.

All that means we can’t help you decide for sure if taking that prepayment penalty makes sense for you, your business, and your loan… But we can cover some common situations and considerations.

Let’s start with a few whys and wherefores.

Why Would I Prepay?

1. Getting out of debt

Sometimes you just want your loan payments to end. Being in debt—having to pay back borrowed money, in other words—can often be stressful, frustrating, and tiring. Even if the terms of your loan are pretty good, you might just be feeling exhausted by those daily, weekly, or monthly bills.

Prepaying can definitely seem like a great path to clear up those regular payments and feel in charge of your capital. But while clearing up your obligations to your lender can be comforting, it may not be your best move—as we’ll discuss.

2. Influx of cash

Maybe you’ve fallen into a surplus of spending money, and it seems like paying your loan off early is the natural way to use it. This isn’t the same reason as above—it doesn’t cut into your cash flow because it’s an unexpected windfall—but they both revolve around the same thought: if I can prepay even with the prepayment penalty, why wouldn’t I?

3. High interest rates

Paying off a high interest rate loan early can save you a good amount of money in the long run—and plus, if your business is doing well, you can probably afford loans with lower interest rates that don’t cut into your cash as much.

Or maybe your loan is tying you down in another way. It could be holding collateral that you want to free up, or it could have a balloon payment waiting at the end of its term that you want to sidestep. Compare what you’ll save by prepaying, plus what you’ll lose with the prepayment penalty, with what you’d otherwise spend by waiting out the loan’s full term.

No matter the reason, thinking financially about taking on a prepayment penalty makes sense—as long as you’re aware of the other factors that might be involved.

4. Refinancing

Refinancing is a lender’s worst nightmare.

Okay, so that’s a little overdramatic—but they don’t like it. If you’re refinancing your loan, your lender doesn’t get an opportunity to peg you with late fees, since you’re guaranteed to pay in full and on time. They also don’t want to reward you for taking your business to a competitor, so your lender might not recognize that prepayment “incentive” if you refinance.

On the other hand, it’s perfect if you want to replace a high interest loan with a longer, lower interest one, or consolidate several loans into a single product. Either way, your prepayment penalties come into effect when you refinance, so be aware that they’ll have an impact on how large of a refinancing you need.

What Factors (Besides the Prepayment Penalty) Should I Be Thinking About?

Maybe you fall into one, some, or none of those camps. Either way, here are a couple things to think about before deciding whether to prepay your loan. Consider whether the potential costs outweigh the reason you’ve landed on.  

1. Amortization Schedule

Not all loans get paid off the same way. Check your loan’s amortization schedule to understand where, in the life of your loan, your lender stacks the principal versus the interest.

So that’s a bit confusing. Think of it this way: while you might pay the same amount every month for a loan, that payment doesn’t need to split equally between the principal—the amount you actually borrowed—and the interest—the extra money you’re spending for the privilege of borrowing.

Commonly, lenders will horde the interest payments in the front of the loan, and the principal payments way in the back. This way, even if you do prepay, the interest you’re forgiven on will probably sit below the average.

For example, say you take out a 10 month $10,000 loan at 10% interest. (All those tens make the example easier to see—you probably won’t ever get a loan as wacky as this one.) The total interest you end up paying will be $1,000, and the total repayment after 10 months will be $11,000.

But that doesn’t mean you’re paying $1,000 of the principal and $100 of the interest every month. If your lender prioritizes interest in the beginning and principal in the end, you might have paid something like $800 of the interest and only $3,000 of the principal back after the first 6 months. You’d only have $200 of interest left, but $7,000 of the principal—so you can see how saving on the last 6 months’ interest payments might actually not outweigh a big flat rate prepayment penalty.

The point is that you should make sure you know how much you’d actually be saving and spending on a prepayment, because it could be less than you think.  

2. Cash flow

It’s tempting to think of prepaying your loan in theory, but not in practice.

While a loan might cut into your cash flow on a daily, weekly, or monthly basis, prepaying the entire remainder of that loan at once would definitely take out a nice chunk. Picture a big shark instead of a bunch of sardines. So it may feel good to get those loan payments out of the way ahead of time, but your business simply might not be able to withstand that big of a cash shortage.

In this case, a prepayment penalty would just be a cherry on top—but if you’re thinking about prepayment, then it’s not something you can disregard.

3. Cash Usage

On a different (but related) note, is prepaying your loan the best use of that cash?

Maybe you could invest in new equipment, inventory, or marketing. Or maybe it’s best for your business to just keep that cash on hand, as a cushion for other payments or seasonal losses. What’s important is that you don’t get tunnel vision: just because you can prepay a loan, that doesn’t mean you should.

4. Taxes

You can declare the interest on your business loan payments as deductible on your tax returns… But if you pay off the loan early, then you’ll be showing more profits and paying higher taxes.

Depending on the size of your business and your own financial stability, this could be a minor issue or a major consideration.

5. Business Credit Score

Even with a prepayment penalty, your lender won’t make as much from your loan if you prepay. There’s a chance—slim, but there—that your lender could report an unsatisfactory (though full) repayment of your loan, which might bring down your business credit score. The fix is simply to speak with your lender and make sure this won’t happen—or only partner with honest lenders.

There you go! Now the next time someone asks you whether they should prepay their business loan, you can charge them five bucks for a lesson on prepayment penalties. Or just point them here. Either way—happy borrowing!

The post Prepayment Penalty: What Happens When You Pay Early? appeared first on Fundera Ledger.

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