Prepayment Penalty: What Happens If You Pay Off Your Loan Early?

What Is a Prepayment Penalty?

A prepayment penalty is a fee you’ll have to pay if 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 prepayment penalty fee is a percentage of your loan’s total remaining balance.

Being in debt is stressful. Even if the terms of your business loan are pretty good, it’s easy to feel exhausted by those daily, weekly, or monthly bills. And paying your loan off early can seem like a logical way to release the burden of those payments and free up your cash flow. But the fear of your small business loan’s prepayment penalty might stop you from getting out of your loan too soon.

Essentially, prepayment penalties ensure that the lender can recoup the interest they’re owed, even if a borrower pays down their debt ahead of schedule. So, prepayment penalty clauses in your business loan agreement will make it hard for you to save on avoided interest if you pay down your debt early.

Here’s the good news: For the most part, small business loans don’t have specific prepayment penalty clauses in their terms. However, that’s not to say you’ll always save money by paying down your business debt early, even if your loan doesn’t come with a prepayment penalty.

Long story short, prepayment penalties can be one of the more confusing parts of taking on business debt. But whether a prepayment penalty is specifically outlined in the loan’s terms, or it’s baked into the loan product itself, it’s crucial to understand what prepaying your loan will cost you.

What Is a Prepayment Penalty?

A prepayment penalty is a fee you’ll have to pay if 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 prepayment penalty fee is a percentage of your loan’s total remaining balance.

Why Prepayment Penalties Exist

Even a simple prepayment penalty definition 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. That loss is what a prepayment penalty is meant to mitigate.

Unlike mortgage and car loans, though, most small business loans don’t include 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. 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. Take a look at your business loan’s repayment schedule—if it’s an amortized loan schedule and there’s no prepayment penalty clause, you’ll be forgiven your avoided interest if you pay down your debt early.

Prepayment Penalties in Their Different Forms

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 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.

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 Loan Prepayment Penalties

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 is an annualized indication of a loan’s total cost). Multiply your factor rate by the amount of capital you’re borrowing, and that’s the 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 you won’t be saving any interest if you decide to get out of that loan early.

Merchant Cash Advance Prepayment Penalties

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 prepayment penalty clause in a merchant cash advance agreement, you nevertheless won’t be able to save by paying down your debt 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. 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, 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 amortization schedule?

As a reminder 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?

Although 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 a portion of that deductible with the interest you avoid paying.

Prepayment Penalty Clauses: Wrapping It All Up

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!).

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