What Is a Prepayment Penalty: What To Look Out For

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.

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Prepayment penalties are usually based directly or indirectly on the remaining loan balance. The longer the business owner has had a loan and the less they will owe, the smaller the penalty will be. For example, if you pay off your loan a few months early, you won’t face a huge fee. Paying off years early might lead to a large fee.

A prepayment penalty may sound like punishment for paying off a loan quickly - especially for a small business owner struggling to get out of debt or expand their business. However, prepayment penalties ensure that the lender can recoup the interest they're owed, even if a borrower pays down their debt off early.

Prepayment penalty costs – what to look out for

How can you tell if you’ll save money or not on interest by paying early? Determine if loan is amortized. Here are details you need to know from Investopedia:

  • An amortized loan is a loan with scheduled periodic payments that are applied to both principal and interest.
  • An amortized loan payment first 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’ve taken out an amortized loan with no prepayment penalty clause, you’ll be forgiven interest by paying down the debt early.

Loans that might have 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. For example, working capital and debt refinance SBA loans through banks in the SmartBiz network have a ten year term. That means no prepayment penalties. You can pay off your loan any time without an additional cost.

However, SmartBiz Loans also offers commercial real estate SBA loans with a 25 year term through their network of banks. There is a 5% prepayment penalty if the loan is paid off in first year, 3% in second year, and 1% if paid off in third year. After the third year, there are no prepayment penalties for the remaining life of the loan.

Merchant cash advances

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’re easy to qualify for and funds can be available in just a few days. Because of the fixed fees, you can’t save on interest by paying off your MCA early even though there’s not specific repayment penalty language in your loan agreement.

Personal loans

Terms and rates vary widely, but lenders can assess prepayment penalties in most cases. Review the terms of your agreement before making any extra payments to avoid paying more in the long run.

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Home mortgages

Some conventional home loans charge prepayment penalties if you pay them off within the first few years. There are states that put caps on how much lenders can charge for prepayment penalties and the federal government bans lenders from them on FHA mortgages.

Auto loans

Prepayment penalties for auto loans vary depending on the lender and state. (Approximately 70% of states allow them) 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 on a business loan

  1. Read the fine print. Be aware of all costs, fees, and penalties before you sign on the dotted line. Find a lender who is transparent by looking for reviews from real customers. Google Reviews, TrustPilot, ConsumerAffairs, and the Better Business Bureau are good places to find first-hand information about lenders.
  2. Shop around. When it comes to small business loans, there are lots of lenders and loan products out there. If you anticipate being able to pay off a loan early, seek out lenders who do not charge these fees.
  3. Negotiate. Some lenders may forgive the prepayment penalty if you negotiate.

Final thoughts

If you’re 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. You’ll find out if you’ll save money in the long run – or if this move will cost you.

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