Did you take out a loan to get your business started? Have you been trying to pay that loan off as quickly as possible?
Many business owners (and people, in general) assume that they need to pay off their loans as soon as they can. That might not always be the best approach, though.
In fact, paying off your loan too quickly could lead to a prepayment penalty.
If you’re brand new to the idea of a prepayment penalty, keep reading. Listed below are seven important facts you ought to know.
1. What is a Prepayment Penalty?
First things first, let’s clarify what a prepayment penalty is.
A prepayment penalty is a type of borrower fee. As the name suggests, it is a penalty that you will pay if you pay off your loan earlier than you’re supposed to.
What is the point of this penalty, though? Wouldn’t a lender want to get their money back as quickly as possible, rather than waiting on regular monthly payments?
You’d think that’d be the case. But, you have to remember that your loans come with interest. That interest is how lenders make a profit.
If you pay back your entire loan at once and avoid paying interest each month, the lender misses out on months’ worth of profits.
To avoid losing interest (and profits), many lenders charge a penalty.
2. Loans That Come With Prepayment Penalties
Some common types of loans that business owners take out that come with prepayment penalties include the following.
Small Business Administration (SBA) Loans
A loan from the Small Business Administration (SBA) will have specific prepayment penalties laid out in their terms.
The most popular type of SBA loan is an SBA 7(a) loan. This kind of loan is available for a maximum of $2 million and comes with an SBA loan guarantee of a maximum of $1.5 million.
If the loan term is less than 15 years, SBA 7(a) loans don’t come with a penalty. If the term is longer than 15 years, though, there is a penalty if you pay the loan off within the first three years.
If you pay the loan off within the three years, you’ll have to pay 5 percent, 3 percent, and then one percent of the amount you prepaid each year for three successive years.
A short-term loan may also come with a prepayment penalty.
This is because lenders often use a money factor or factor rate, which gives you a fixed amount of interest (rather than an interest amount that accrues over time).
With a factor rate, you’ll always have to pay off that fixed amount of interest, no matter how quickly you repay the loan.
Basically, you don’t save any money by paying off a short-term loan with a factor rate ahead of schedule.
3. Reasons to Continue Paying Interest
Initially, the idea of a prepayment penalty can be pretty frustrating? Who wants to be forced to spend more time paying interest?
The thing is, there are some perks to continuing to pay interest on a loan. For starters, there’s the lack of a penalty. There’s also the tax benefits.
You can additionally write off the interest you’re paying on your business loan. When you’re first getting your business off the ground, you’ll probably want to take any opportunity you can get to deduct money from your final tax bill.
If you prepay your loan, you’ll miss out on that deductible.
4. How are Prepayment Penalties Calculated?
There are a few different methods lenders use to calculate prepayment penalties:
Percentage of Loan Balance
Sometimes, a lender will charge you a percentage of your loan balance. If you owed 100,000 dollars and the loan had a prepayment penalty of three percent, you would pay a $3,000 penalty.
Some lenders also focus on how much interest they would have earned if you’d kept the loan for its entire term. For example, they might require you to pay six months’ worth of interest as a penalty for paying off your loan early.
5. Questions to Ask Before Paying Your Loan Off Early
If you’re on the fence about paying your loan off early, start by asking yourself these questions:
- How will paying the loan off early influence my cash flow?
- Can I even afford the penalty?
- How will paying the loan off early affect my taxes?
You’ll also need to consider whether or not your loan amortizes. This means that, as the term of the loan goes on, a greater percentage of your payment goes toward the principle and less of the payment goes toward interest.
6. Benefits of Paying Off a Loan Early
At the same time, there are also some situations in which it’s beneficial to pay your business loan off early.
For example, if you’re looking to get a new loan (perhaps with better interest rates or for a higher amount), having extra debt can hurt your chances of getting approved. It might be better to pay the loan off (with the fee) to get more money from a different lender.
7. How to Avoid Prepayment Penalties
The easiest way to avoid prepayment penalties is to stick to the payment schedule outlined by your lender. There are other steps you can take to avoid prepayment penalties, though, including:
- Prepay a portion of your loan every year (most lenders will allow you to pay a certain percentage without facing a penalty)
- Shop around and look for loans that don’t come with any prepayment penalties
- Wait for the loan out to bypass the penalty (some loans only charge a penalty if you pay it back within a certain time period)
You might also want to consider selling an asset. Some lenders will waive the penalty if you prepay by selling an asset. Check the terms of your loan to see what your lender will allow.
Want to Learn More?
You’re now up to speed on how a prepayment penalty works. But, are you looking for more information on managing your business’s finances?
We’ve got lots of resources on our website that can keep you informed on the most important aspects of money management for business owners.
We can also help you get the money you need to get your business off the ground and keep it afloat.
Are you in need of more cash for your business? We’re here for you at Dealstruck. Contact us or apply for a loan online today.