Let’s say you are a custom drum manufacturer, and an order comes in that you couldn’t fill without purchasing additional inventory. To cover the costs of the inventory, you choose to take out a short-term loan, borrowing $20,000 with the agreement to pay it back over the course of a year.
The loan works out well; the large order was fulfilled, and your money came back tenfold. But now you’re left with loan payments that are cutting directly into your cash flow.
At this point, it seems like a good idea to pay your loan off early, right? After all, doing so would free up your cash flow and you’d no longer have that debt looming over your head. But while paying your loan off early seems ideal, doing so can get you slapped with a hefty prepayment penalty.
What is a prepayment penalty?
To put it simply, some lenders include a prepayment penalty, or prepayment fee, with their loan agreements in order to deter borrowers from paying off their loans early. This way, lenders receive the amount of money they originally anticipated no matter when the load is paid off.
Think about it this way—the interest is the price you pay for borrowing money. Or, in other words, the interest is where lenders makes their profit. So if you agreed to a short-term loan with a repayment period of one year, but decide to pay it off in 6 months—without the prepayment fee, lenders would miss out on all that cash.
So even though your intentions are good, paying your loan off early isn’t always going to save you any money. But of course, this all depends on your particular loan agreement, and what type of prepayment penalty your lender charges—if at all.
What kind of prepayment penalties are there?
Just because your loan comes with a prepayment penalty doesn’t necessarily mean you’ll be losing money if you pay it off early. In order to figure that out, it’s important to understand what type of penalty you agreed to.
The prepayment penalties on small business loans come in varying forms; you may be required to pay a lump sum, flat-rate penalty, you may have to pay a percentage of the remaining balance, or there may be a reducing penalty—meaning that the further you are into your loan agreement, the less your prepayment will cost you.
Short-term prepayment penalties
It’s important to note that not all small business loans come with prepayment penalties. The most popular loan type you’ll see them on is short-term loans. But short-term loans tend to be a little tricky. Lenders may not list a prepayment fee specifically on their loan agreement. However, you won’t be forgiven of any interest in the event that you do pay your loan off early. So essentially, you will be penalized for the early payoff, even if that’s not exactly clear on your loan agreement.
Most traditional loans “amortize,” and you know exactly how much you’re paying towards your principal and towards interest. When you want to pay that loan off early, you’ll know exactly how much of the principal remains, and are “forgiven” any remaining interest.
But with short-term loans, you might simply be put on a payment plan. Whenever you want to pay it off early, you have no idea what’s left on your principal and what’s left on your interest, make it a lot more difficult to figure what needs to be repaid. So some lenders might make you pay back the total amount, while others might make you pay a remaining percent, or some other fee. Either way, it’s very important you understand this any time you take on a loan, no matter the loan type. With some short-term lenders, it might not save you money in the end to pay back your loan early.
Other reasons you may want to prepay your loan
Still, there are a number of reasons that repaying your loan early might make sense. Maybe you simply hate having debt, or you have a sudden influx of cash (i.e. the money from your large order coming back tenfold), or maybe you’re trying to free up your debt to take on new financing. But if your goal is to cut down on the cost of your loan, you will need to do your homework to make sure that paying it off early will achieve that result.
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business.