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If you are looking for a business loan, be sure to ask about prepayment penalties. A prepayment penalty, also known as a “prepay”, is an agreement between a borrower and a bank or other type of lender that regulates how much of the loan a borrower is allowed to pay off and when.
Prepayment penalties are based directly or indirectly on the remaining loan balance. The longer the business owner has a loan the less the will owe and the smaller the penalty will be. If you pay off your loan early, you will not face a large fee.
Prepayment penalties ensure that the lender can recoup the interest they are owed, even if a borrower pays down their debt off early.
What You Need to Look Out For
To be able to know if you will save money or not on interest by paying early, you need to determine if the loan amortized. An amortized loan is a loan with periodic payments that are applied to both principal and interest. An amortized loan payment pays off the interest expense for the period while the remaining amount reduces the principal. As the interest portion of the payments for an amortization loan decreases, the principal portion increases.
If you have taken out an amortized loan with no prepayment penalty clause, you will be forgiven interest by paying down the debt early.
Loans with Prepayment Penalties
SBA 7(a) Loans
If the term of your SBA 7(a) loan is less than 15 years, there is no prepayment penalty. Working capital and debt refinance SBA loans have terms that last years meaning there is no prepayment penalties on them. You can pay off your loan any time without an additional cost.
Merchant Cash Advance
A merchant cash advance (MCA) is not a loan in the traditional sense. If you take out an MCA, a financing company advances cash to you in a lump sum. They then take a percentage of your daily credit card and debit card sales, on top of charging a fee. MCAs are attractive to small business owners in need of fast funding. They are easy to qualify for and funds can be available in just a few days. Because of the fixed fees, you cannot save on interest by paying off your MCA early even though there’s not specific repayment penalty language in your loan agreement.
Personal Loans
Lenders can reassess prepayment penalties in most cases and terms and rates vary widely. Review the terms of your agreement before making any extra payments to avoid paying more in the long run.
Home Mortgages
Some conventional home loans charge prepayment penalties if you pay them off with the first few years. There are states that put caps on how much lenders charge for prepayment penalties and the federal government bans lenders from them on mortgages.
Car Loans
Prepayment penalties for auto loans vary depending on the lender and state. Loans under 48 months are commonly charged a prepayment penalty.
Student Loans
There are no prepayment penalties for private and federal student loans. Borrowers are able to pay balances early through larger payments than required or by paying off in one lump sum.
Tips to Help You Avoid Prepayment Penalties
- Read the fine print and be aware of costs, fees, and penalties before you sign the paperwork for the business loan. Find a lender who is transparent by looking for reviews from real customers.
- Shop around. When it comes to small business loans, there are lenders and loan products out there for you. Seek out lenders who do not charge any fees if you think you will be able to pay off a loan early.
- Some lenders may forgive the prepayment penalty if you negotiate.
The Bottom Line
If you are considering a small business loan with a prepayment penalty, discuss with your lender the exact details. Once you have all the information, run the numbers to discover what you’ll owe if you pay off the loan early or refinance it.
