If you took out a loan to fund your small business, it wasn’t done lightly. You had to create a business plan and demonstrate the value this funding would have on your business. Then, you had to confidently predict your ability to repay the loan at the agreed terms.
What happens if a sudden windfall leaves you flush with more cash than you expected? Perhaps you experience an incredible surge in demand, access to capital at a lower rate, or a winning lottery ticket. You now have the ability to pay off your loan earlier than expected. Should you do it?
The answer? It depends. Depending on the kind of loan you took out, and how that loan was structured, you may be charged a prepayment penalty to get out of debt early. And even if you don’t, you may not save any money by paying off your loan early either.
Prepayment penalties on small business loans are rare, but they do exist. Understanding what a prepayment penalty is, and how it might affect your decision to prepay, is crucial before you even take out a loan.
What is a prepayment penalty?
A prepayment penalty is a fee levied against the borrower by the lender for paying off their loan early. These penalties are spelled out in the loan contract. The exact amount depends on how the penalty is structured and varies case-by-case.
Prepayment penalties can take the following forms:
- Lump-sum flat rate penalty: A set amount that represents a chunk of interest, such as three or six months’ worth of your loan.
- Percentage of remaining balance penalty: For however of your much remains to be paid off, you’ll be charged a percentage of that amount.
- Reducing penalty: This penalty depends on how much of your loan you’ve already paid off. The more you’ve paid off, the smaller your fee.
- Short-term loan penalty: You may not be forgiven any of the interest if you pay off your short-term loan early, and thus would just be tying up capital.
Prepayment penalties are a way for lenders to ensure they make money off your interest payments, as they intended. Lenders spend time and resources underwriting and administering your loan. They want to recoup that investment whether you pay early or not.
Which small business loans have prepayment penalties?
Most small business loans do not have prepayment penalties. These penalties are way more common with mortgages and other personal loans. But that doesn’t mean prepayment penalties on loans for small businesses don’t exist, or that it makes sense to always pay your loan off early.
Here’s a short list of the types of small business loans that may write a prepayment penalty into your loan contract:
SBA loans
Small Business Administration loans are considered some of the best on the market. The SBA partially guarantees these loans, encouraging the banks that disperse the funds to extend more generous terms to borrowers.
There are, however, a couple of SBA loan options that come with prepayment penalties. If you have a 7(a) SBA loan with repayment terms longer than 15 years, or a CDC/504 loan (which typically has repayment terms ranging from 10-25 years), you’ll be subject to a penalty if you prepay too soon.
When you are reviewing your loan terms for an SBA loan, make sure you note whether or not your loan comes with a prepayment penalty and when it kicks in.
Short-term loans
Short-term loans are loans that should be repaid in 12 months or less. These loans likely don’t have a specific monetary prepayment fee outlined in their contract. They may instead be structured in a way that disincentivizes you from paying early, however.
Some short-term loan lenders may quote you a “factor rate” (or “buy rate”) rather than an interest rate. Don’t compare factor rate and interest rate—they aren’t the same thing.
Traditional term loans are amortizing, which means they’re gradually paid off in regular installments that are the same each month. Each payment is a combination of the outstanding principle and the interest on that principle.
What About Loans With Factor Rates?
Loans with factor rates, however, are structured differently. All of the interest is charged up front. Your factor rate is a multiplier that tells you how much you’ve been charged. This is an amount that will remain fixed no matter if you pay back early or not.
For example, a factor rate of 1.3 on a $10,000 loan means that you’ll pay $10,000 multiplied by 1.3, which is $13,000. You will owe your lender $13,000 regardless of whether you stick to your schedule. This excludes late payments, of course, which will hit you with late fees.
You might be considering merchant cash advances, which are also calculated with a factor rate. Additionally, keep in mind that though MCAs—which is when a lender advances you funds in exchange for a future cut of your daily credit card sales, plus fees—are a quick source of money, they can be extremely expensive and should only be considered as a last resort.
If I don’t have a prepayment penalty, should I go ahead and pay off this loan?
Not always.
If you’ll save money on interest due to the way your loan is structured, and that savings is enough to make a difference to you, then by all means, paid it off.
But, think carefully before you move to wipe that loan off your books with this extra money. Is paying off your loan the best use of your extra funds?
Theoretically, you already have a plan for paying off this loan on the terms you were given. Could you keep paying your loan and instead use your extra money to bankroll a new online marketing campaign, get a deal on bulk inventory, or just keep in your rainy day fund in case of emergency?
Also remember that business loan payments are deductible on your tax returns. By paying off your loan entirely, you lose the ability to deduct the interest on your loan payments.
To Pay Off Your Loan Early, Or Not?
When it comes to paying off your loan early, either you’ll save on interest or you won’t. It all depends on the terms you agreed to when you took out funding in the first place. Do your due diligence before agreeing to any sort of financing. You will understand exactly what’s expected of you, no matter when you make your payments.
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. Meredith 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.