If you’re considering applying for a business loan, you might have come across the idea of prepayment penalties. The name “prepayment penalty” probably gives you a concept of what the concept entails, however, you might be curious as to exactly how prepayment penalties work, how common they are among business lenders, and how to minimize the consequence of prepayment penalty if you wish to repay your loan early.
Read on for any full guide to prepayment penalties and how to mitigate their effects.
What Is A Prepayment Penalty?
A prepayment penalty is really a financial penalty that applies to borrowers looking to repay financing ahead of the predetermined schedule.
If you repay your loan early in an effort to save money on charges (or for every other reason) and the terms of the loan include a prepayment penalty clause, you’ll have to pay a problem which will reduce or eliminate the amount of money you’ll save by repaying the loan early.
While that describes the basic results of prepayment penalties, these penalties don’t always operate in exactly the same way. With respect to the type of mortgage and your loans, prepayment penalties comes in various forms. I’ll walk you through few different types of such penalties to inform you how these penalties can hit you in different ways.
Prepayment Penalty Example
In most instances, a prepayment penalty is assessed like a percentage of the outstanding loan balance that you pay off. In this circumstance, let’s say your debt $100,000 on a loan which you then decide to pay off immediately, in front of schedule. Let’s think that the loan agreement specifies a prepayment penalty of 4% of the outstanding loan balance. Which means that you’ll pay $104,000 back to the lending company — the $100,000 balance plus a $4,000 prepayment penalty.
Prepayment penalties may also be based on the amount of interest you would have otherwise paid had you repaid the borrowed funds based on schedule. In that instance, instead of paying a portion from the outstanding loan balance, you’ll have to pay an amount equal to three or six months’ price of interest payments in your loan whenever you pay off the balance.
Note these aren’t the only real kinds of prepayment penalties. We’ll discuss a few other forms later.
Why Business Lenders Require Prepayment Penalties
Lenders lend in order to make a profit. These profits come in the type of charges. When you repay financing early to save money on interest payments, the lender constitutes a smaller profit off the loan than anticipated.
A prepayment penalty may be the means by which lenders disincentivize paying down loans early and be sure they get compensated — either partially or in full — for just about any interest they'd miss out on due to a borrower paying down financing early.
Where You Might Encounter A Prepayment Penalty
Mortgages and auto loans commonly feature prepayment penalties, but such penalties are less common in the business lending world. However, some types of business loans do disincentivize paying early, through either prepayment penalties or through the structure from the loan itself.
SBA Loans
SBA loans are unique within the lending world, as the terms are set through the government. One of the ways most SBA loans distinguish themselves from more typical business loans is they spell out specific prepayment penalties. For instance, with SBA 7(a) loans — the most typical type of SBA loan — borrowers who prepay 25% or more of the loan with a term of Fifteen years or longer are susceptible to a prepayment penalty when they make the payment within 3 years of the initial loan disbursement. The penalty only applies if one makes this payment within 3 years of disbursal and its amount is dependant on when you help make your prepayment:
- Prepay during year 1 and also the penalty is 5% of the amount of the prepayment.
- Prepay during year 2 and the penalty is 3% from the amount of the prepayment.
- Prepay during year 3 and the penalty is 1% of the quantity of the prepayment.
Short-Term Business Loans
When you take out a short-term business loan, the loan agreement probably won’t incorporate a specific prepayment penalty. However, that’s because the structure from the loan itself penalizes prepayment.
Instead of the interest rate, short-term loans have a factor rate, which is a flat fee that is calculated when your loan proceeds are disbursed. The fee is a number of your borrowing amount, and you will owe this amount regardless of whether you have to pay back the loan on schedule or ahead of schedule.
What To Do If You Have Financing Having a Prepayment Penalty
Depending on your loan, there are a variety of the way you are able to avoid or minimize the impact of the prepayment penalty while still making early payments on your loan.
Make Partial Prepayments
If the loan agreement allows for it, you may be capable of making partial prepayments without penalty. For instance, SBA 7(a) loans impose a prepayment penalty on repayments within the first three years of a loan only if such repayments add up to 25% or even more of your loan. Therefore, should you prepay 20% of your SBA 7(a) loan within your newbie, you won’t reach this threshold and also you won’t be subject to a prepayment penalty.
Make Prepayments Following the Fluctuating Penalty Goes Down
Some prepayment penalties specify a problem rate which goes on the further you receive in to the loan term until it disappears entirely. In the case of SBA 7(a) loans, a prepayment of 25% or even more of your loan in the newbie of your term (assuming a total term period of Fifteen years or longer) is penalized in a 5% rate. However, if you hold back until your third year to make this same prepayment, the penalty rate falls to 1%, and when you make this prepayment in your fourth year, you won’t need to pay a prepayment penalty whatsoever.
Prepayment Penalty FAQs
How common are prepayment penalties on loans?
Many loans don't impose prepayment penalties. However, there are kinds of loans that do discourage paying off your loan early, whether through prepayment penalties or with the inherent structure from the loan.
For example, the most typical types of SBA loans impose prepayment penalties on all prepayments above a number of the total loan amount, with the penalty dependent on how many years into the loan term you are whenever you make the prepayment.
While short-term loans will not explicitly impose prepayment penalties, making prepayments may not help you save any money due to the fact the fixed fee imposed through the lender must be paid regardless of when you pay off the loan (though some short-term lenders do incentivize paying early by reduction of the fixed fee if you prepay). This is correct of merchant payday loans too.
How can I know if my loan has a prepayment penalty?
Look through your business loan agreement to ascertain if a prepayment penalty pertains to your loan and if so, study the nature of the fee and how it's calculated.
How do I avoid paying a prepayment penalty?
The easiest way to avoid paying a prepayment penalty would be to only accept a loan if no prepayment penalty is roofed in the loan agreement. In case your loan agreement does penalize prepayment, you may be in a position to avoid or minimize its effects by prepaying a sum that doesn’t get to the threshold at which a penalty applies (in the case of SBA 7(a) loans, this really is 25% of the total amount borrowed) or by looking into making prepayments later on in your loan term when the penalty might have been down or disappeared entirely.
Final Ideas on Prepayment Penalties
Lenders want borrowers to pay for just as much interest as you possibly can, which is why some loans discourage and penalize early payment through the use of prepayment penalties. However, using the strategies outlined in the following paragraphs, you might be capable of making prepayments in your business loan while avoiding or minimizing any penalties, even when the loan does incorporate a prepayment penalty.
- SBA Loans: What They Are & The way they Work
- Short-Term Loans Explained
- What Is A Factor Rate?
- Merchant Cash loan Guide
- Small Business Term Loan Calculator
