What is a prepayment penalty and what to look out for

Looking for a business loan? Be sure to ask about prepayment penalties. These penalties can arise if you repay your loan before your term ends. That might sound counterintuitive – why would you pay more for doing something that your lender expects you to do, just early? Below, you’ll learn why some lenders charge a prepayment penalty, which loans might include prepayment fees, and how you may be able to avoid them.

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What is a prepayment penalty?

A prepayment penalty is a fee a lender may charge you for repaying your loan before your term ends. Also known as a “prepay,” this penalty stems from 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 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 your 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 early.

Loan amortization and prepayment penalties

How can you tell if you’ll save money or not on interest by paying early? A good first step is determining if your loan is amortized. Here are some details you should know:

  • 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

1. 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, which means there are no prepayment penalties. You can pay off your loan any time without an additional cost.

2. 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.

3. 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.

Personal loan lenders often charge prepayment penalties as a flat fee or a percentage of your remaining loan balance. Others charge a prepayment penalty equivalent to the total interest you would pay over your loan’s lifetime if you didn’t pay early. These fees can be so high that certain personal loan providers heavily advertise their lack of prepayment penalties to attract customers.

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4. Home mortgages

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

Home mortgage prepayment penalties typically don’t apply if you make just a few occasional extra payments to pay off the mortgage more quickly. Principal-only payments typically aren’t subject to prepayment fees either. The most common occasions that trigger mortgage prepayment penalties include refinancing your mortgage, selling your home, or paying an unusually large portion of your loan.

5. 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.

You might sometimes see auto loan prepayment penalties referred to as “percentage penalties” or “rule of 78s.” Another term, “precomputed loans,” means your auto lender will use your interest rate to calculate your total lifetime interest. You’ll then have to pay this interest whether or not you repay your loan early. Though technically not a penalty, the logic behind this loan clause is the same as with a repayment fee.

6. 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.

However, when repaying federal student loans early, you’ll need to contact your loan provider and tell them not to place you on paid-ahead status. Services that see you designated as such will delay your next payment. While that sounds good in theory, the result is less credit available toward any loan forgiveness payments. No such concerns apply for private student loans – you can prepay them with absolutely no fees or other concerns.

Tips to help you avoid prepayment penalties on a business loan

  • 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.
  • 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.
  • Make partial early payments. Some lenders only charge prepayment fees if you repay the whole loan. That might mean you can pay off part of your loan without any penalty. If you see this sort of agreement in your loan contract, try to put aside some money each month. Target a certain percentage of your loan in savings. Then, pay that amount all at once. You can make smaller payments thereafter until your term ends, without any fees.
  • Negotiate. Some lenders may forgive the prepayment penalty if you negotiate. For example, you could ask your lender to lower your prepayment fee percentage by a certain amount after each year of your loan term. The goal would be to get your fee down to zero percent for the final 12 months of your term. This way, the lender can still charge a prepayment penalty for the most part, and you can still repay slightly early.
  • Only repay early after a certain amount of time. With some loans, you might not have to make the above negotiations since similar provisions are part of your contract in the first place. If these terms are already in your loan, don’t prepay until enough time has passed that you can do so without penalty. Then, prepay your loan – you’ll clear your balance as desired, all without any of those pesky fees.

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.

SmartBiz can help you navigate loan options that offer more repayment flexibility. Check now whether you pre-qualify* for SBA 7(a) loans, bank term loans, or custom financing options.

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*We conduct a soft credit pull that will not affect your credit score. However, in processing your loan application, the lenders with whom we work will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and happens after your application is in the funding process and matched with a lender who is likely to fund your loan.

WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.

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