by Meredith Wood
So you took out a business loan to help you with the costs of expanding your company and in hopes of increasing your annual revenue. Fortunately, the loan helped you achieve your goals and now you have enough cash coming in to completely pay off your debt. The question is… should you?
It sounds great, after all, paying off your loan means freeing up your cash flow and no longer being a prisoner to those timely monthly payments. Unfortunately, as nice as washing your hands of those loan payments sounds, sometimes paying it off early can actually cost you more. The reason? A little thing lenders refer to as prepayment penalties.
What is a prepayment penalty?
Before you go paying off your loan with all that extra cash, read the fine print of your loan agreement. What you may have missed the first time around is that your loan comes with a prepayment fee or prepayment penalty. This is something borrowers sometimes include in their loan terms as a way of deterring borrowers from paying off their debt early. Why, you ask?
As you know, loans don’t come free. They come stacked with interest, and that interest is how lenders make money off their lending services. For instance, if you take out a 12-month loan, and decide to pay it off after just four months, the lender is missing out on eight months of interest to fill their pockets with.
This is why lenders will charge prepayment penalties—they don’t want to miss out on all that cash. So unfortunately, even if you do have the cash on hand to pay off your debt early, it may not end up saving you money to actually do so.
How prepayment penalties work
A prepayment penalty on a small business loan is not a one-size-fits-all scenario. In fact, the penalties you might find listed in the terms of your loan come in varying forms. You may have a flat-rate penalty and be required to pay a lump sum, you may have to pay a percentage of the remaining balance, or you may be dealing with a reducing penalty.
The good news is, having a prepayment penalty attached to your loan doesn’t always mean you’ll be losing money, however. In order to figure out just how much your fees will cost you, it’s important to know what type of penalty your lender charges.
The flat rate
With a flat rate prepayment penalty, or fee, lenders charge you a lump sum if you pay your loan off early. Typically they’ll determine the amount of the penalty based upon the terms of your loan. For instance, the lender may decide that for three year loan, you’ll have to pay six months worth of interest.
If this is the type of penalty attached to your loan, there is a small silver lining. It can be easy to figure out what your penalty will be, thereby making it easy for you to figure out if prepaying off your debt will help you or hurt you.
The percentage penalty
Plain and simple—with a percentage penalty, you’ll be required to pay a percentage of your remaining balance in order to settle up with the lender. For example, you might have a 20 percent prepayment on $5,000, which means you’ll pay $1,000 on top of your remaining balance.
If you have a reducing penalty attached to the terms of your loan you may luck out—depending on when you choose to pay off your loan, that is. Since this penalty is calculated on a sliding scale, the penalty will change depending on how far along you are in the terms of your loan.
As an example, let’s say you choose to fully pay off a three-year loan after just one year. You may incur a 5 percent penalty at that time. But if you choose to pay it off after two years, your penalty will be reduced, and you may only be hit with a 1 percent penalty. Generally speaking, the less you have to pay off, the less of a penalty you incur.
Reducing penalties are typically found on longer-term, fixed-rate loans.
Short-term prepayment penalties
Short-term prepayment penalties tend to be a little trickier than the ones we’ve listed above. The reason behind this is because, although a lender may not be planning to forgive you of any interest, they may not actually list any prepayment fee in their loan agreement.
Basically, because short-term loans don’t amortize, the line isn’t clear between whether payments you’re making are on interest or principal. In these cases, the full amount of interest applies from day one of the loan—so you’ll pay the full interest amount regardless of when you choose to pay off your loan. Unfortunately, this means paying off your loan early might not save you any of your hard earned cash.
Know what you’re signing up for
There are a number of reasons you may want to pay your loan off early, but if saving money is one of them, you’ll want to know what penalty—if any— is actually attached to your loan. This way you can figure out the exact figure you’ll be paying, and if the early payoff is worth it.
To truly protect yourself from prepayment penalties and fees, always carefully read the terms of any small business loan product before you sign the dotted line.
Meredith Wood is the editor-in-chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. She is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more.