Understanding prepayment penalties

Getting a loan can help you grow your business, but figuring out the cost of paying off a loan isn’t always straightforward. In addition to paying interest on the funds you borrow, you may also have to pay a number of fees, depending on your lender and loan type. 

Commonly overlooked charges include origination fees, processing fees, documentation fees, wire transfer fees, late payment fees, and prepayment penalties. 

A prepayment penalty is a fee a lender charges if you pay off some or all of your loan ahead of schedule. If, for example, your sales skyrocket one year and you have enough cash to pay down your loan before your loan term is up, you may receive a penalty for doing so. That fee is usually a small percentage of your total loan amount.

While getting paid back early may sound like a good thing for lenders, charging interest is how most of them make a profit, so it behooves them to have borrowers pay on a predetermined schedule.

Which types of loans have prepayment penalties?

Mortgages and car loans typically have prepayment penalties, but fortunately, most small business loans don’t. Still, there are a couple of common types of business loans where paying early may come with fees. 

1. SBA 7(a) loan: The Small Business Administration’s 7(a) loan is for businesses that need help getting started, expanding, refinancing debt, purchasing a building, renovating, or buying equipment. The prepayment penalty applies to loans with maturities of 15 years or more that are prepaid within the first three years. For example, if you received a 20-year term loan to purchase a building, but want to repay your loan in full sometime within the first three years, you’d pay a penalty of 5% if you prepaid the first year, 3% the second year, and 1% the third year.
2. Merchant cash advance: With a merchant cash advance (MCA), a lender gives you money upfront in exchange for a percentage of your future sales. MCAs don’t have prepayment penalties, but they do use fixed factor rates instead of interest rates. That means you have a set number of fees you’re required to pay no matter what, and won’t save money on interest by paying your loan early.

How to decide whether or not to pay your loan early

Getting out of debt is appealing, but paying a loan early may not be the best financial choice for your business. There are numerous factors to consider when making your decision, including your interest rate and the cost of the prepayment penalty, as well as your business’ growth opportunities, finances, and goals.

You may want to consider paying off your loan early if:

• You can save money on interest. A prepayment penalty may amount to a large chunk of money, but if the fee is less than what you would continue to pay in interest for the remainder of your loan term, it could be worth it to pay in advance.
• You want to apply for another loan. If your current loan has less favorable terms, like a tricky payment schedule, high interest rates, or a hefty annual processing fee, you may want to terminate your contract and apply for a loan that better suits your business.
• You want to consolidate your debt. Owing money can be stressful. If you have multiple forms of debt and want to reduce the amount of cash that leaves your business each month, paying your loan off early could save you headaches and help simplify accounts payable.
• Your finances are in good shape. Paying off a loan early is a big financial commitment. If your business has positive cash flow and a strong cash flow forecast, though, then paying ahead of time could free you up to take on new projects or invest your money elsewhere.

On the other hand, consider keeping your loan payment schedule normal if:

• You won’t save money on interest. If your loan has fixed factor rates or if you’re close to the end of your term, then paying early won’t necessarily put your business in a better financial place.
• The prepayment penalty is steep. If you have limited cash flow or tight profit margins, paying a hefty prepayment fee could set your business back financially and make it harder to maintain operations or pursue future growth opportunities.
• You want to invest in other growth initiatives. Depending on your goals and the stage your business is in, paying off your loan early may not be the best use of your extra funds. If you’re trying to expand or increase profits, you may want to put your money toward growth projects instead, like hiring a new salesperson or opening a new location.
• You don’t want to lose tax deductions. The interest you pay on loans is tax deductible, but if you pay off your loan early, and thus avoid paying interest, you’ll lose some of your deduction.  

There are both advantages and disadvantages to prepaying a loan. Weigh your options carefully and consider consulting a financial advisor to ensure you’re setting your business up for success.

Disclaimer: Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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