Prepayment Penalties: What to Know Before Paying Off Early
Understanding prepayment penalties on business loans: how they work, which loans have them, how to calculate costs, and strategies to minimize their impact.
Prepayment penalties are fees charged when you pay off a loan early. They protect lenders from losing expected interest income. For borrowers, they can turn what seems like a smart financial move into an expensive mistake.
Understanding prepayment penalties before you sign a loan agreement is critical. Here is what you need to know.
Why Prepayment Penalties Exist
Lenders include prepayment penalties because:
- Interest income protection: Lenders expect to earn interest over the loan term
- Origination cost recovery: It costs money to underwrite and fund loans
- Investment returns: Loan portfolios are priced assuming certain durations
- Discourage refinancing: Makes it harder for competitors to poach borrowers
Types of Prepayment Penalties
Prepayment penalties come in several forms:
| Type | How It Works | Example |
|---|---|---|
| Percentage of balance | Fixed percentage of remaining principal | 3% of $100K = $3,000 |
| Percentage declining | Percentage decreases over time | 3% year 1, 2% year 2, 1% year 3 |
| Interest differential | Remaining interest owed | All interest through maturity |
| Months of interest | Set number of months interest | 3 months interest on balance |
| Yield maintenance | Compensates for reinvestment loss | Complex calculation based on rates |
Prepayment Penalties by Loan Type
Different loan products have different prepayment structures:
| Loan Type | Typical Prepayment Penalty | Notes |
|---|---|---|
| MCA | None (must pay full factor) | Early payoff requires paying all fees anyway |
| Online term loan | 0-5%, often declining | Many have none after 6-12 months |
| Bank term loan | 1-3% declining | Usually none after year 2-3 |
| SBA 7(a) | 3% year 1, 2% year 2, 0% after | Applies only to loans with 15+ year terms |
| SBA 504 | Not allowed first 10 years | Very restrictive; some exceptions |
| Equipment loan | Varies; 0-5% | Often none or minimal |
| Line of credit | Usually none | Revolving nature makes penalties rare |
SBA Loan Prepayment Rules
SBA loans have specific prepayment rules set by federal regulation:
- SBA 7(a) loans with 15+ year terms: 3% if paid in first year, 2% in second year, 0% after
- SBA 7(a) loans under 15 years: No prepayment penalty
- SBA 504 loans: Generally cannot prepay for first 10 years without paying all interest
- Partial prepayments: Rules vary; some allow partial payments without penalty
SBA 504 Flexibility
SBA 504 prepayment restrictions have some exceptions. If you are refinancing to another SBA loan or have significant business changes, discuss options with your CDC.
How to Calculate Prepayment Costs
Before paying off early, calculate actual savings vs. penalty:
- Step 1: Get exact payoff amount (principal + accrued interest)
- Step 2: Calculate prepayment penalty based on your loan terms
- Step 3: Add remaining payments if you kept the loan
- Step 4: Compare: payoff + penalty vs. remaining payments
Example calculation:
| Scenario | Amount |
|---|---|
| Current balance | $75,000 |
| Remaining interest if held to maturity | $8,500 |
| Prepayment penalty (2%) | $1,500 |
| Total to pay off early | $76,500 |
| Total if held to maturity | $83,500 |
| Net savings from early payoff | $7,000 |
MCA "Prepayment": A Different Situation
Merchant cash advances do not have traditional prepayment penalties, but early payoff is not free:
- Factor rate is fixed: Whether you pay in 6 months or 12, you owe the same total
- No discount for early payoff: The $65,000 payback on a $50,000 advance is $65,000 regardless of timing
- Effective APR increases: Faster payoff means higher annualized cost
MCA Early Payoff Math
Paying off an MCA early does not save money. If anything, it makes the effective cost higher. Only pay off early if you are refinancing into a lower-cost product.
Strategies to Avoid or Minimize Penalties
Before taking a loan:
- Negotiate upfront: Ask for no prepayment penalty or reduced terms
- Choose products wisely: Lines of credit typically have no penalties
- Match term to need: Shorter-term loans may have shorter penalty windows
- Review declining schedules: Wait until penalty reduces or expires
If you have a loan with prepayment penalty:
- Time your payoff: Wait until penalty period expires if practical
- Make extra payments: Some loans allow additional principal without triggering full penalty
- Partial paydown: Pay down balance to reduce penalty amount before full payoff
- Negotiate with lender: Some will waive or reduce penalties for good customers
When Early Payoff Makes Sense Despite Penalty
Sometimes paying the penalty is worth it:
- Refinancing to much lower rate: Savings exceed penalty
- Selling the business: Clean balance sheet required
- Freeing up cash flow: Monthly payment elimination has strategic value
- Removing personal guarantee: Worth the penalty for peace of mind
- Accessing better financing: Current loan blocking better opportunity
Questions to Ask Before Signing
Before accepting any loan, ask:
- Is there a prepayment penalty?
- How is it calculated?
- Does it decline over time? When does it expire?
- Are partial prepayments allowed without penalty?
- Can the penalty be negotiated or waived?
- What is the exact payoff calculation process?
Getting Your Payoff Amount
When ready to pay off:
- Request payoff letter: Get exact amount in writing
- Include good-through date: Payoff amounts change daily with interest accrual
- Verify penalty calculation: Make sure it matches your loan agreement
- Request UCC termination: Confirm lender will release security interest
- Get confirmation: After payment, obtain written confirmation loan is satisfied
Allow Processing Time
Request your payoff letter 5-7 days before you plan to pay. Wire transfers can take 1-2 business days to post. Build in buffer time to ensure payment arrives before the good-through date.
Prepayment Penalty Red Flags
Watch out for these concerning provisions:
- Entire interest charge: Required to pay all interest regardless of payoff timing
- No declining schedule: Same penalty whether year 1 or year 4
- Excessive percentages: Penalties over 5% are unusual for most products
- Hidden in fine print: Penalty terms buried in lengthy agreements
- Verbal assurances: "Do not worry about it" without written confirmation
Always read the prepayment section of your loan agreement carefully. If you do not understand it, ask for clarification in writing before signing.
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Read more →Important Disclosure
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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