What Is A Prepayment Penalty?

When you’re considering small business loans, some lenders have prepayment penalties.  What exactly is a prepayment penalty, and how can it affect your small business? Even some of the best loans for small businesses might have prepayment penalties, so it’s important to be prepared.

We’ll answer that question and more in this full guide to prepayment penalties.

What Is A Prepayment Penalty?

A prepayment penalty is a financial penalty that applies to borrowers looking to repay a loan ahead of the predetermined schedule.

If you pay your loan off early to save money on interest payments and the terms of your loan include a prepayment penalty clause, you’ll end up paying a penalty that might completely eliminate the amount of money you’d save by repaying the loan early.

This scenario is a basic explanation of prepayment penalties, but they don’t always work the same way for all lenders. It all depends on the terms of your loan. Prepayment penalties can come in different forms.

Why Do Business Lenders Require Prepayment Penalties?

Lenders are in the business of lending to make money. Their profits come from the interest payments their customers make on their loans. When you pay a loan off early to save yourself money, your lender makes less money off of your loan than anticipated.

A prepayment penalty is a lender’s way of disincentivizing their borrowers from paying off their loans early, ensuring that they get compensated (either partially or fully) for any interest they’d miss out on.

Examples Of Prepayment Penalties

• Assessed As A Percentage: In this situation (which is most common), your penalty is a percentage of the outstanding loan balance that you pay off. Ex: You owe $100,000 on a loan that you pay off immediately. Your loan agreement specifies a prepayment penalty of 4%. This means you’ll be paying $104,000 total back to the lender.
• Scheduled Interest: Some prepayment penalties will require you to pay the amount of interest you would have paid on the loan on the schedule originally agreed upon. Instead of paying a percentage of the outstanding loan balance, you’ll pay a sum equal to three or six months’ worth of interest payments on your loan if you pay it off early.

What Loans Have Prepayment Penalties?

It isn’t as common to see prepayment penalties in the business lending industry, but some still do disincentivize paying early, either through prepayment penalties or the structure of the loan itself. It’s more common to see prepayment penalties in the terms of mortgages and car loans.

What To Do If You Have A Loan With A Prepayment Penalty

Depending on your loan, there are a couple of ways you can avoid or minimize the impact of a prepayment penalty while still making early payments on your loan.

Final Thoughts On Prepayment Penalties

Lenders want borrowers to pay as much interest as possible, which is why some loans discourage and penalize early payment through the use of prepayment penalties. However, using the strategies outlined in this article, you may be able to make prepayments on your business loan while avoiding or minimizing any penalties, even if your loan does include a prepayment penalty.

For a more detailed rundown of the rates and fees that apply to business loans, check out our guide to business loan rates and fees.