What is a Prepayment Penalty?
Understanding prepayment penalties in business loans, when they apply, and how to evaluate whether early payoff makes financial sense.
A prepayment penalty is a fee charged when you pay off a loan before its scheduled maturity date. Lenders impose these penalties to recoup the interest income they lose when borrowers pay early.
Why Prepayment Penalties Exist
When lenders make loans, they budget for a certain amount of interest income over the loan term. Early payoff disrupts their projections and reduces their return. Prepayment penalties compensate for this lost income.
Fixed-rate loans more commonly have prepayment penalties because the lender locked in their cost of funds for the full term. Variable-rate loans often have no penalty since rates adjust to market conditions.
Common Prepayment Penalty Structures
Prepayment penalties take several forms:
- Percentage of balance: Often 1%-5% of the remaining principal
- Declining percentage: Higher early in the loan, decreasing over time (e.g., 5% year 1, 4% year 2, 3% year 3)
- Yield maintenance: Complex calculation to make the lender whole based on current rates
- Lock-out period: No prepayment allowed for a set period
Example
You have a $300,000 loan with a 3% prepayment penalty that declines 1% annually. After 18 months, you want to pay off the remaining $250,000 balance. Your penalty would be 2% (the year-2 rate) times $250,000, equaling $5,000.
SBA 504 Prepayment
SBA 504 loans have a declining prepayment penalty on the CDC portion: typically starting around 3% and decreasing each year until it reaches zero around year 10.
When Prepayment Still Makes Sense
Sometimes paying the penalty is worthwhile:
- Refinancing to a significantly lower rate that offsets the penalty
- Selling your business or the underlying property
- Eliminating debt to improve cash flow or qualify for other financing
Always calculate the net savings after the penalty before deciding. If you save $15,000 in future interest but pay a $5,000 penalty, you still come out $10,000 ahead.
Negotiating Prepayment Terms
Before signing, understand the prepayment terms and try to negotiate. Options include shorter lock-out periods, capped penalties, or no penalty after a certain number of years. Strong borrowers with multiple offers have more leverage to negotiate favorable terms.
Variable-rate SBA 7(a) loans typically have no prepayment penalty. If flexibility to pay early matters, this may influence your loan choice.
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Not Financial Advice: The information provided in this article is for general informational purposes only and does not constitute financial, legal, or professional advice. You should consult with qualified professionals before making any financial decisions.
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