Understanding Prepayment Penalties on Business Loans
When you take out financing to cover a business expense and pay off the financing ahead of schedule, it may result in a prepayment penalty. Depending on the type of loan and lender you choose, you could be subject to prepayment penalties that ensure the lender can collect a certain amount of money from you, whether that’s in the form of interest or a fee. Prepayment penalties for businesses are often associated with U.S. Small Business Administration (SBA) loans and commercial real estate loans.
What is a prepayment penalty?
A prepayment penalty is a fee that lenders charge you if you attempt to pay off your debt early. Early payoff penalties most commonly accompany mortgages and auto loans, although some types of business loans come with these fees, too.
Lenders generally make their profit through collecting interest from borrowers. A prepayment penalty ensures the lender can still profit from a loan if borrowers don’t make their full interest payments.
The prepayment fee is typically a percentage of your total loan amount. Any fees associated with ending your loan early should be disclosed in your loan offer or final loan agreement. You may think that paying off business debt early would allow you to save money, and while that may be true, you could still pay hundreds or thousands of dollars in prepayment fees.
What types of business loans carry prepayment penalties?
You may encounter prepayment penalties with certain types of SBA loans, and commercial real estate loans. SBA loans are issued through partner lending institutions — typically banks — while you can find commercial real estate loans from either a traditional bank or online commercial lender.
SBA 7(a) loans
These SBA loans for general business expenses come with prepayment penalties if the loan’s repayment term exceeds 15 years. The penalty would apply if you voluntarily pay 25% or more of your outstanding 7(a) loan balance within the first three years of your loan term. The fee amount would be based on the timing of your prepayment:
- 1st year: 5% of the amount of the prepayment
- 2nd year: 3% of the amount of the prepayment
- 3rd year: 1% of the amount of the prepayment
SBA 504 loans
These SBA loans are designated for the expansion or purchase of commercial real estate, as well as large equipment purchases. SBA 504 loans have prepayment penalties that decline throughout the first half of the 20-year loan term. The early payoff fee drops from 3.00% the first year to 0.00% from years 11 to 20.
Commercial real estate loans
Commercial real estate loans help business owners buy property, such as storefronts or office space. Traditional commercial real estate loans are similar to home mortgages in that your property would act as collateral and you’d be expected to make loan payments on a set schedule. In some cases, your lender may impose a “lockout” period that prohibits early repayment. Once the lockout is over, your prepayment penalty usually decreases over time, similarly to the penalties that the SBA imposes.
- Defeasance: Prepaying certain commercial real estate loans, such as CMBS loans, may require a process called defeasance. You’d need to replace the property with another asset as collateral to release the lien on the current real estate. In some cases, defeasance may not be available until you reach a certain point in your repayment term.
Where to find business loans with no prepayment penalty
Many online business lenders offer loans and lines of credit with no prepayment penalties. Online business loans also typically have more lenient borrower requirements and faster time to funding than bank or SBA loans. But watch out for high interest rates and fees that often accompany this fast financing.
As you start your search for financing with no prepayment penalties, here are a few online lenders that may meet your needs.
OnDeck offers short-term business loans between $5,000 and $250,000 and a business line of credit between $6,000 and $100,000. Both financing options have 24-month terms to repay debt but OnDeck borrowers have the option to prepay. You may be able to qualify for OnDeck’s Prepayment Benefit, which would allow you to prepay your loan balance in full and waive all remaining interest without facing a penalty or fee (OnDeck does not offer this perk for certain industries).
However, loans that come with the Prepayment Benefit may come with a higher interest rate than loans without the benefit. This would increase the overall cost of the loan despite early payment. And if you don’t receive the benefit but still want to pay off your loan early, you would owe 75% of the remaining interest on your loan.
American Express Business Line of Credit
American Express Business Line of Credit offers revolving lines of credit available up to $250,000. Once you make a withdrawal, you would have either 6, 12 or 18 months to repay the borrowed money amount plus fees. American Express Business Line of Credit does not charge prepayment penalties. Once you pay your debt, your full credit line would become available again.
Funding Circle provides term loans between $25,000 and $500,000 with repayment terms between 6 months and 84 months. Funding Circle does not impose any prepayment fees. If you choose to pay back your loan early, you would only be responsible for interest you incurred during the time that you borrowed. Your interest rate and monthly payment amount would be fixed for the life of your loan, making it easy to calculate any early payments you may want to make.
There are several scenarios in which you would be doing your business a favor if you paid off your debt early. Some of the prepayment benefits for your business could include:
- You can get out of a loan that has bad terms, poor rates or came from a lender with unscrupulous business practices.
- If you have multiple forms of business debt, paying down eliminates a monthly payment, making your bills a little simpler each month.
- Eliminating a monthly loan payment would free up cash you could put toward the company. If your business has seen a spike in cash flow, you may want to pay off the loan and invest more heavily in the business.
Of course, whether or not you pay off a business loan early would depend on your lender’s restrictions. If you face a major penalty for prepaying, you should stick to your original repayment term. Also, if paying early won’t save your business any money — if the lender will collect the same amount of interest regardless — then prepaying may not be the best move for your business. Be sure to consider your original loan agreement and your business’s financial position before deciding to prepay your debt.
Prepayment penalty FAQs
What is prepayment of a loan?
Prepaying a loan means making payments outside of your scheduled repayment term. On some loans, paying off your debt early could help you save on interest. But some lenders prohibit prepayment and charge a fee for making early, unscheduled payments.
Is it good to pay off a loan early?
Whether or not paying off a loan early is a good idea would depend on your specific loan and your business circumstances. If your lender does not charge prepayment penalties and you’d save on interest by paying early, then it may be a smart move. But if paying early does not save you any money, then you may not want to make extra payments that could cut into your company’s cash reserves.
Do SBA loans have prepayment penalties?
Yes SBA 7(a) and 504 loans have prepayment penalties. For 7(a) loans, the fees only apply to loans with terms exceeding 15 years, and only if you pay more than 25% of your balance in the first year. On the other hand, 504 loans have prepayment penalties that decrease during the first 10 years of the loan, reaching 0% at the halfway point in your loan term.