What Are Prepayment Penalties & Do All Business Loans Have Them?
If you’re considering applying for a business loan, you may have come across the concept of prepayment penalties. The name “prepayment penalty” probably gives you an idea of what the concept entails, but you may be curious as to exactly how prepayment penalties work, how common they are among business lenders, and how to minimize the effect of a prepayment penalty if you want to repay your loan early.
Read on for a full guide to prepayment penalties and how to mitigate their effects.
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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 repay your loan early in an effort to save money on interest payments (or for any other reason) and the terms of your loan include a prepayment penalty clause, you’ll have to pay a penalty that will reduce or eliminate the amount of money you’ll save by repaying the loan early.
While that describes the basic effects of prepayment penalties, these penalties don’t always work in the same way. Depending on the type of loan and your loan terms, prepayment penalties can come in various forms. I’ll walk you through a few different examples of such penalties to show you how these penalties can hit you in different ways.
Prepayment Penalty Example
In most instances, a prepayment penalty is assessed as a percentage of the outstanding loan balance that you pay off. In this circumstance, let’s say you owe $100,000 on a loan which you then decide to pay off immediately, ahead of schedule. Let’s assume that your loan agreement specifies a prepayment penalty of 4% of the outstanding loan balance. This means that you’ll be paying $104,000 back to the lender — the $100,000 balance plus a $4,000 prepayment penalty.
Prepayment penalties can also be based on the amount of interest you would have otherwise paid had you repaid the loan according to schedule. In that instance, instead of paying a percentage of the outstanding loan balance, you’ll have to pay a sum equal to three or six months’ worth of interest payments on your loan when you pay off the balance.
Note that these aren’t the only types of prepayment penalties. We’ll discuss a few other forms later.
Why Business Lenders Require Prepayment Penalties
Lenders lend in order to make a profit. These profits come in the form of interest payments. When you pay off a loan early to save money on interest payments, the lender makes a smaller profit off your loan than anticipated.
A prepayment penalty is the means by which lenders disincentivize paying off loans early and ensure that they get compensated — either partially or in full — for any interest they would miss out on due to a borrower paying off a loan early.
Where You Might Encounter A Prepayment Penalty
Mortgages and car loans commonly feature prepayment penalties, but such penalties are less common in the business lending world. However, some types of business loans do disincentivize paying early, either through prepayment penalties or through the structure of the loan itself.
SBA loans are unique in the lending world, as 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 proceeds 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 number 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.
Prepayment Penalty FAQs
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. For even more information on the subject, the following resources should help!