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How to Understand Business Loan Prepayment Penalties
February 16, 2022
Understanding Business Loan Prepayment Penalties

How to Understand Business Loan Prepayment Penalties

When evaluating the cost of your business loan, interest rates are the first thing that comes to mind. However, while rates are important, prepayment penalties can also significantly affect the cost of your loan.

The fee associated with a prepayment penalty generally ranges from one to five percent of your prepayment amount. So in most cases, a prepayment fee will cost you at least a few thousand dollars.

Financing is expensive enough without prepayment penalties, but if you understand them, you can avoid them. To help you avoid incurring these fees, let’s define what they are, why they exist, and how they work. To wrap up, we’ll list the types of small business loans that you can find that don’t have prepayment penalties.

What is a Prepayment Penalty? 

A prepayment penalty is a fee on certain loans that lenders charge when borrowers pay their loan back early. Depending on the loan terms, lenders assess prepayment penalties when borrowers pay off all or a large portion of their loan early.

How Do Prepayment Penalties Work?

Lenders charge prepayment penalties based on a percentage of the prepayment amount. So if you pay $100,000 back early and assume the prepayment penalty fee is one percent, you’d pay $1000.

Oftentimes, prepayment penalty amounts also depend on when you prepay. For SBA 7(a) loans, prepayment penalties on 15-year loans are five percent in year one, three percent in year two, and one percent in year three. However if you pay early anytime after year three, you don’t incur a prepayment penalty.

Of course, SBA 7(a) loans are just one example of a loan program that comes with prepayment fees. Prepayment penalty structures may differ on other types of loans.

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Why Lenders Charge a Business Loan Prepayment Penalty

Whether it’s on a business loan or any other loan type, lenders charge prepayment fees to:

  1. Discourage early payments or extra payments
  2. Recover losses associated with prepayment.

The reason lenders incur losses when prepayment occurs is because they lose out on your future interest payments. Also, if your lender packages and sells your loan to an investor, the risk of your prepayment falls on the investor.

By charging a prepayment fee, lenders make their loans more attractive to investors because there’s a lower risk of prepayment. Also, if lenders hold your loan on their books, they can use the funds from a prepayment penalty to compensate for the loss of interest income.

Should You Pay Off a Loan Early? 

Without knowing your precise situation, it’s impossible to say whether you should prepay a loan. Fortunately, the math isn’t complicated and you can use a calculator like this one to determine potential savings or losses from prepayment.

Still, you should look beyond the math and think about how prepayment might impact your operations. Even if prepayment saves you money on your loan, it will cost you free cash flow. If you can afford to restrict cash flow and still invest in your business then prepaying may be a good business decision.

Business Loans with Prepayment Penalties

There are many kinds of loans that might come with a prepayment penalty. Therefore, it’s a good idea to ask your business loan lender if there’s a prepayment fee anytime you’re considering a loan. However, you should pay extra mind to the following loans, which often have prepayment penalties:

Personal loans for business

If you’re considering using a personal loan for your business, look out for prepayment penalties. Not all personal lenders will charge penalties for paying off a loan early, but some will. If possible, opt for personal loans without prepayment penalties.

SBA loans

SBA 7(a) loans have prepayment penalties on loans with a maturity of 15 years or more for the first three years. Other loans from the SBA may also carry prepayment penalties with different structures. Prepayment penalties for SBA 504 loans, for example, extend out to year ten.

Business auto loans

With both consumer and business auto loans, prepayment fees are common. If you’re using financing to buy a vehicle for your business, make sure you’re aware of this.

Commercial real estate loans 

On commercial real estate loans, prepayment fees are especially significant. In fact, if you want to avoid a penalty for prepaying a commercial real estate loan, you may need lawyers to create a defeasance account. This is a complex, expensive process that also requires financial experts.

All this to say, generally you should try to avoid prepaying a commercial real estate loan. When weighing your options, be sure to ask your mortgage lender if they have prepayment fees. If they do charge these fees, you may want to re-consider the offer.

Conclusion: Don’t Forget About Prepayment Penalties

Many business owners don’t plan to prepay their loans, so they end up glossing over the subject of prepayment fees. This is a mistake; even if you don’t think you’ll pay off your loan balance early, it’s always good to keep options open.

While you won’t have a choice with all loan types, if you do, try to find loans without prepayment penalties. Also, if you’re interested in learning more about loan penalties or fees that you may have overlooked read our post on the top ten small business loan fees.

Fora Financial

Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.

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Fora Financial is a working capital provider to small business owners nationwide. In addition, the Fora Financial team provides educational information to the small business community through their blog, which covers topics such as business financing, marketing, technology, and much more. If you’d like to see a topic covered on the Fora Financial blog, or want to submit a guest post, please email us at [email protected].