Prepayment Penalties: When the Early Bird Doesn’t Get the Worm

It’s every small business owner’s dream: you took out a business loan to start or expand your small business, and it really paid off. Business is booming, cash is flowing, and you suddenly find yourself in the coveted position of being able to pay off your loan far before you anticipated.

While you’ve always wanted to fill your bathtub with bills and jump in, you know the wiser choice would be to pay off that pesky loan once and for all.

Because the early bird gets the worm, doesn’t it?

You might be shocked to hear this, but not always. Before you rush to your lender with a check in hand, slow down. Beyond the reasons why paying back your loan early might not be the best use of your extra income, you could actually be charged a penalty for paying off your loan before the anticipated date outlined in your contract.

What is a Prepayment Penalty?

While many factors go into figuring out what is considered a true prepayment penalty, the term is most easily defined as a clause in your loan contract that states a penalty will be assessed if your loan is paid down or paid off within a certain time period.

Getting penalized for paying off your loan balance early might feel like a punishment. We all know about late fees, but early fees? Really? It seems just backwards enough to make you ask…

But Don’t Lenders Want Their Money Back Sooner?

You would think that most lenders would be delighted for you pay back their money early, but this is usually not the case. As with any for-profit business, the goal of business lenders is to make a profit off of you borrowing money.

This profit is made in the interest a lender charges you while you are borrowing their money. If you return that money sooner than expected, the lender loses out on the interest they were expecting to charge you for the full term of the loan. The solution to this is the prepayment penalty—it exists to ensure that the lender will make their profit whether you pay them interest on their money for the full term of the loan, or if you pay it off early.

While many lenders and loan products don’t come with prepayment penalties attached, if you’ve made moves to pay off your business loan and discovered that your loan is subject to a prepayment penalty, it’s going to take some serious soul-searching and calculator-crunching to arrive at the best choice for you.

Weighing Your Options

When trying to come to a decision about whether or not to pay off your business loan early, it’s helpful to first understand the terms of your specific loan. There are several types of business loans that may come with prepayment penalties attached.

• The Traditional Term Loan: this type of loan is most likely to have a prepayment penalty. This is because they usually come with fixed interest rates and fixed monthly payments, and generally have the longest repayment terms around. If you paid off this loan early, the lender would lose out on a fair amount of interest, so a prepayment penalty is affixed to secure their profit.
• SBA Loan: while almost all loans through the Small Business Administration’s loan program do not have prepayment penalties, there is one exception—a loan with a maturity of 15 years that you pay off in 3. Again, this stems from the fact that this early of a repayment would cut into a substantial portion of the lender’s interest.
• Short-Term Loan: though this type of loan will likely not have a hard monetary prepayment penalty, the lender may recoup their loss of interest in the event of early payment by increasing the Annual Percentage Rate (APR) of your loan, which is the loan’s interest rate plus additional fees.

After identifying which type of loan you have, the next most important step is of course to pinpoint which type of prepayment penalty is attached to your loan.

• Flat Rate: this type of prepayment penalty is easily understood—the lender calculates a fee relative to your loan terms and asks you to pay a lump sum upon early payment of your loan.
• Straightforward Penalty: this is a clause that costs you a certain percentage of your remaining interest regardless of other factors.
• Sliding Scale Penalty: this penalty is what it sounds like—the earlier you pay off your loan, the bigger the penalty.

Other Factors

While the hard numbers are certainly important when it comes to deciding if it’s worth paying off your business loan early, there are other factors to consider as well. Let’s take a look at the biggest pros and cons to paying off your loan early:

Pro

• No more debt: if the emotional factor plays a big role in your life and you’re tired of your loan hanging over you, it may be worth the prepayment penalty for you to live debt-free. This is a personal choice that only you can make!
• Make hay while the sun shines: as small business owners know, business can be feast or famine. If you have a sudden influx of cash, there is a valid point in wanting to pay off your loan while you are in the “feast” part of the cycle.
• High interest rates: run the numbers and see. If your loan has high interest rates, it may save you money in the long run to pay it off early, despite the prepayment penalty.

 Con

• Cash flow: while paying off your loan would feel great, you have to ask yourself if it’s the best use of your extra cash. Dig deep and determine if your business can really withstand a cash shortage from paying off your loan, or if it would be smarter to invest in new equipment, inventory, or marketing. And it’s always a wise move to start a rainy day fund for unexpected expenses.
• Taxes: the interest on your business loan payments is tax deductible, but if you pay off the loan early, you’ll show more profit and have to pay higher taxes.
• Business credit score: if your lender is unhappy with your early payment, they could report full but unsatisfactory payment of your loan, which would lower your business credit score. Before making the decision to pay off your loan early, be sure to discuss this with your lender.

The Takeaway

Only you can decide if paying off your loan early and potentially facing a prepayment penalty is right for you and your small business. The key to leaving the option of early payment open to your business is to read the fine print of your loan before entering into an agreement. Ask your lender about their policies on prepayment penalties before taking on a loan, and you’ll be setting up your small business for the greatest flexibility in the future.