Being in debt is stressful. Even if the terms of your business loan are pretty good, you might just be feeling exhausted by those daily, weekly, or monthly bills—and prepaying your loan can seem like a logical way to release the burden of those payments, free up your cash flow, and allow you greater control over how you spend your money.
But the fear of your small business loan’s prepayment penalty might stop you from getting out of your loan too soon.
If you have a mortgage or a car loan, you’re probably familiar with the concept of prepayment penalties. Essentially, these fees prevent lenders from paying early, and ensure that the lender is paid all the interest they’re owed. Here’s the good news: For the most part, small business loans don’t have specific prepayment penalties in their terms. However, it’s not always in your best interest to pay your loan early, even if you have the cash to do it.
Before you put down that huge payment all at once, you need to know whether you’ll actually end up saving money by paying your loan early. Then, you’ll need to consider your small business loan’s prepayment penalty—whether it’s specifically outlined in the loan’s terms, or if it’s baked into the loan itself—and how it might affect your business’s finances.
What Is a Prepayment Penalty?
A prepayment penalty is pretty much what it sounds like: If the terms of your loan include a prepayment clause, then you’ll be penalized if you pay off your debt early. Typically, that charge is a percentage of your loan’s total remaining balance.
This might sound a bit counterintuitive: Why wouldn’t your lender want all their money upfront, rather than waiting on those monthly payments?
Keep in mind that the money you’re repaying comes stacked with interest, and that interest is how the lenders make a profit. So, if you decide to repay a loan six months early, your lender loses six months of interest on that loan balance.
Unlike mortgage and car loans, though, most small business loans don’t include prepayment penalty clauses in their terms. However! 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. That’s because small business loans either incentivize or disincentivize paying loans early, depending on how they’re structured.
In other words, you’ll either save money on interest by paying early, or you won’t. It’s pretty simple, really. You just have to know whether your loan is amortized or not.
A Quick Rundown on Amortizing Loans
Put simply, “amortization” means paying off your debt in regular installments, which is probably what you think of when you think of traditional loans.
Amortized loan bills are comprised of two facets: the principal—the amount you actually borrowed—and the interest—the extra money your lender charges, at a particular rate, for the privilege of borrowing.
But monthly payments for amortized loans don’t always equally comprise principal and interest, even though you’re paying the same amount every month. Rather, the combination of principal payments and interest payments changes over time. Often, lenders frontload loan bills with interest and push the principal payments way in the back. This ensures that the lender receives the interest they’re due as soon as possible.
The important thing to know now, though, is that you’re paying interest on top of your principal every single month. So, if you pay off an amortized loan months before the term is up, you’ll be forgiven for the remaining interest on your loan.
Let’s say you have a 12-month term loan: Every month, you’re paying some amount of interest, and some amount of principal. But, if you can pay the total amount of your loan in six months, then you’ll be saving six months’ worth of interest.
Most medium-term loans amortize, as do most equipment loans.
→TL;DR (Too Long; Didn’t Read): Most small business loans don’t have prepayment penalty clauses in their terms—rather, you’ll either save on interest by prepaying your small business loan, or you won’t. If you’re able to prepay an amortized loan, such as a medium-term or equipment loan, you’ll end up saving on interest.
Which Types of Loans Have Prepayment Penalties?
Again, most small business loans don’t include prepayment penalty clauses in their terms. However, some loans simply don’t incentivize prepayment, like amortized loans do—so you’re not guaranteed to save money in the long run if you pay off every type of loan early.
In particular, it might not be worth prepaying the following types of loans:
SBA Loans
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.
If you’re lucky enough to get an SBA loan, it’s likely to be an SBA 7(a) loan, since it’s by far the most popular SBA loan program. Here’s how SBA 7(a) prepayment penalties work:
- If your loan term is less than 15 years, there’s no prepayment penalty.
- If your SBA 7(a) loan term is 15 years or more, you’ll be hit with a prepayment penalty if you pay off your loan within the first three years.
- In that case, you’ll have to pay 5%, 3%, then 1% of the amount you prepaid, respectively, for three successive years.
Other types of SBA loans, including SBA 504/CDC loans, come with prepayment penalties attached, too. So, if you have an SBA loan—and you’re able to pay off that loan early—consult its terms to know exactly how its prepayment penalty works (and whether your business can manage that extra fee).
Short-Term Loans
Like most small business loans (other than SBA loans), short-term loans won’t come with a hard monetary prepayment penalty. But a “prepayment penalty” may be baked into the terms of the loan itself.
That’s because short-term loans don’t amortize. Rather, short-term lenders might quote you a factor rate rather than an APR (which includes a loan’s interest rate, among other fees). Multiply your factor rate by the amount of capital you’re borrowing, and that’s the the total amount you owe the lender at the end of your loan’s term. 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 you won’t be saving any interest if you decide to get out of that loan early.
Merchant Cash Advances
Technically, merchant cash advances (or MCAs) aren’t business loans. Rather, 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.
However, it can be difficult to stay ahead of those cuts in your sales, since the MCA provider takes out the same percentage of your sales every day. And, if you’re making a ton of sales, you’ll end up paying that MCA provider a substantial amount of money. Whether your sales are fast or slow, MCAs can cause a serious dent in your cash flow. So, think carefully before signing on for a merchant cash advance.
But, for today’s purposes, here’s what you need to know: 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.
→TL;DR: Certain types of SBA 7(a) loans indicate specific prepayment penalties in their terms. Other types of small business loans likely won’t carry specific prepayment penalties, but you won’t save money if you pay them off early.
Before You Prepay Your Loan, Ask Yourself These 4 Questions
Other than freedom from daily or monthly loan bills, there are lots of reasons why you might want to prepay your small business loan.
For one thing, you may be itching to get out of a bad loan deal—and prepaying a loan with unfavorable terms, like high interest rates, can free you up to apply for a better loan. (Most lenders won’t approve a business loan applications if that potential borrower has substantial existing debt on their books.)
Relatedly, you might want to refinance your business loan, and get a loan with a lower interest rate or a longer repayment term, from another lender—which means paying off your existing loan early.
Finally, you can save a lot of money on interest if you prepay your loan, as long as that loan is amortized.
Whether or not prepaying your loan saves you money, though, paying off that much money all at once can definitely affect your business’s finances overall. So, before you decide to prepay your loan, consider whether prepaying outweighs these potential costs or impacts:
1. What’s my loan’s amortization schedule?
As you (hopefully!) know by now, you’ll pretty much only save by prepaying your loan if that loan amortizes. If that’s the case, check your loan’s amortization schedule. That way, you’ll understand where, in the life of your loan, your lender stacks the principal versus the interest. Paying down your loan early may or may not save you as much on interest as you think.
2. How will prepaying my loan affect my cash flow?
While a loan might cut into your cash flow on a daily, weekly, or monthly basis, prepaying the entire balance of that loan at once would take out a big chunk now. So, it may feel good to get those loan payments out of the way ahead of time, but your business may not be able to withstand that loss in working capital.
3. Is prepaying my loan the best use of my money?
It may be tempting to use the cash earned from a windfall or a high season on getting out from under your debt early. But consider whether prepaying your loan is 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 keep that cash on hand as a cushion during future slow seasons. What’s important is that you don’t get tunnel vision: Just because you can prepay a loan, doesn’t always mean you should.
4. How will prepaying my loan affect my taxes?
You can declare the interest on your business loan payments as deductible on your tax returns. In fact, you can deduct the interest you pay on any kind of loan if you’re using that money toward your business. (But you have to really use that money—any interest you pay on the money in your business bank account isn’t a deductible business expense.) So, if you pay off your loan early, then you’ll lose that deductible.
→TL;DR: Before you plan to prepay your loan, make sure you consider other factors besides just the prepayment penalty. Your prepayment could affect your taxes, cash flow, and more.
What Happens When You Pay Your Loan Early?
The simplest answer? You’ll either save on interest, or you won’t.
Unless they’re SBA loans, most small business loans don’t include prepayment penalties in their terms—unlike mortgages or car loans, which often do. So, without a hard monetary fee, deciding to prepay your loan or not is a matter of financial incentive. Depending on how your loan’s repayment terms are structured, you might save on interest. Or, you might not. It really depends on whether your loan is amortizing or not.
If your loan amortizes, then you can save months’ worth of interest if you pay before its term is up. (Medium-term loans and equipment loans most likely amortize.)
But if your lender quotes a factor rate, then there’s really no financial incentive for you to prepay. That’s because you’re agreeing to repay a fixed amount within a certain timeframe, and your loan bills don’t accrue interest. So, it doesn’t matter whether you pay that total amount now or later—it’s not going to change, so you’re not going to save any money by paying now.
Even if you do have the means, and the desire, to pay your loan early, it’s in your best interest to think about how prepaying will affect your business’s finances overall. Paying off that huge amount now, for instance, will cut into your cash flow more dramatically than monthly loan bills will. Or, you might contribute that surplus of cash toward another worthy cause, like investing in new equipment, covering payroll, or giving yourself a safety net in case your business hit a rough patch.
Before you sign up for your loan, check its exact terms and repayment structure. It’s always a good idea to know exactly what you’re getting yourself into—or, eventually, getting yourself out of (but only if it’s worth it!).
The post Prepayment Penalty: What Happens When You Pay Early? appeared first on Fundera Ledger.
from Fundera Ledger https://www.fundera.com/blog/prepayment-penalty
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