What Is a Prepayment Penalty on a Business Loan?
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Key takeaways
- A prepayment penalty is a fee a lender charges when you pay off a loan before its term ends.
- It is typically assessed as a percentage of the remaining balance of your loan.
- You may be able to avoid a prepayment penalty by negotiating with your lender.
How much do you need?
What is a prepayment penalty?
Why do lenders charge prepayment penalties?
How prepayment penalties work
When it takes effect
How the fee is calculated
- Percentage of remaining balance. For small-business loans, prepayment penalties are commonly structured as a percentage of the balance you are paying off. That means if you have a $100,000 remaining balance and a lender charges a 3% prepayment penalty, your fee will be $3,000.
- Cost of interest. A lender may also choose to charge the remaining amount of the total interest cost on the loan. In that case, you wouldn’t be saving money on interest by paying off your loan early, so you would have to weigh the other benefits of prepaying.
- Flat fee. Although it’s uncommon, lenders may charge a flat fee to pay off your loan early, no matter when you pay it off or how much your remaining balance is. A flat fee might be more beneficial for an earlier loan payoff.
- Scaled fee. Your fee may be adjusted depending on when in your loan’s term you pay the remaining balance — usually the earlier in the term, the higher the fee. Both SBA 7(a) and SBA 504 loans use scaled fee amounts, where the percentage of the balance you pay goes down the longer you wait to pay it off. For 7(a) loans, there is no penalty after three years, and for 504 loans, the penalty drops off after 10 years.
How much are prepayment penalties?
How to avoid paying a prepayment penalty
If you’re still shopping for a loan
If you’ve decided on a lender, but haven’t signed documents
If you already have a loan with a prepayment penalty
How to decide if you should pay your loan off early
- Will I save more on interest than I’ll have to pay? Sometimes because of the fee structure, you may end up saving on interest even if you pay a penalty. Your loan statements should show your remaining balance, and you can use a business loan calculator to determine the interest you have left to pay. Keep in mind the interest you pay on business loans can also be tax deductible, so you’ll want to see how that factors into your long-term financials.
- Do I have other upcoming purchases? Clearing up as much old debt as possible can help you qualify for a new loan if you’re thinking about upcoming purchases to expand and grow your business.
- Will it free up cash flow? Refinancing, paying off or consolidating debt can free up cash flow that’s crucial to the daily operation of your business. In those cases, paying a penalty can be worth the additional cost.