What Is A Prepayment Penalty?

Some loans have prepayment penalties that fine you if you pay back your loan early. Learn more about prepayment penalties in this guide.

WRITTEN & RESEARCHED BY
Kymberlin Bush
Expert Contributor

Last updated onUpdated August 18, 2024

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Key Takeaways

A prepayment penalty is a fee that some lenders charge if you pay off your loan early.
Lenders include prepayment penalties to protect their profits, as they make less money when loans are paid off early and interest payments are reduced.
To minimize or avoid prepayment penalties, consider making partial payments or waiting until the penalty decreases or disappears later in the loan term.

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.

Table of Contents

What Is A Prepayment Penalty?
What Loans Have Prepayment Penalties?
What To Do If You Have A Loan With A Prepayment Penalty
Final Thoughts On 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.

SBA Loans

Small Business Association (SBA) loans are unique in the lending world because the terms are set by the government.

One way most SBA loans distinguish themselves from more typical business loans is that they spell out specific prepayment penalties.

For instance, with SBA 7(a) loans (the most common type of SBA loan), borrowers who prepay 25% or more of a loan with a term of 15 years or longer are subject to a prepayment penalty if they make the payment within three years of the initial loan disbursement. The penalty only applies if you make this payment within three years of disbursal, and its amount is based on when you make your prepayment:

Prepay during year 1, and the penalty is 5% of the amount of the prepayment.
Prepay during year 2, and the penalty is 3% of the amount of the prepayment.
Prepay during year 3, and the penalty is 1% of the amount of the prepayment.

Short-Term Business Loans

When you take out a short-term business loan, your loan agreement probably won’t include a specific prepayment penalty. However, that’s because the structure of the loan itself penalizes prepayment.

Instead of an interest rate, short-term loans have a factor rate, which is a flat fee that is calculated when your loan funds are disbursed. The fee is a percentage of your borrowing amount, and you will owe this amount regardless of whether you pay back your loan on schedule or ahead of schedule.

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.

Make Partial Prepayments

If your loan agreement allows for it, you may be able to make partial prepayments without penalty.

For instance, SBA 7(a) loans impose a prepayment penalty on repayments within the first three years of a loan only if such repayments amount to 25% or more of your loan. Therefore, if you prepay 20% of your SBA 7(a) loan within your first year, you won’t reach this threshold, and you won’t be subject to a prepayment penalty.

Make Prepayments After The Fluctuating Penalty Goes Down

Some prepayment penalties specify a penalty rate that goes down the further you get into the loan term until it disappears entirely.

In the case of SBA 7(a) loans, a prepayment of 25% or more of your loan in the first year of your term (assuming a total term length of 15 years or longer) is penalized at a 5% rate. However, if you wait until your third year to make this same prepayment, the penalty rate goes down to 1%, and if you make this prepayment in your fourth year, you won’t have to pay a prepayment penalty at all.

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.