How to Pay Off a Business Loan Early: 6 Contract Terms to Check

Usually paying off a business loan early is a smart move, because it saves you money on interest. Lenders don’t like to lose interest, though, and may charge a prepayment penalty of 1-5% of the outstanding balance of the loan. Most small business lenders don’t charge such a fee; if yours does, you’ll want to make sure the interest savings are higher than the penalty cost. Look for these six terms in your loan agreement before paying off early:

• whether there is a prepayment clause at all,
• how the fee is calculated,
• what repayment events trigger it,
• whether the fee shrinks over time or has a lockout period,
• whether a defeasance clause applies,
• and, on a merchant cash advance, the factor rate.

Small Business Lenders Charge Prepayment Penalties

Lenders make their profits on the interest. If you decide to pay off a loan early, the lender loses the interest it could have made on that loan. This is the reason some small business lenders charge prepayment penalties. If, for example, you repay six months ahead of schedule, the lender loses six months of interest income, and the fee recoups some of that money. In some cases, the fee drops as you near the payoff date.

To find out if your lender charges a prepayment penalty, look for a clause in the loan contract that says “prepayment clause” or “prepayment penalty.” Prepayment penalty clauses are fairly uncommon for small business loans, but they sometimes appear on SBA loans and commercial real estate loans. Once you sign the loan contract, you’re stuck with the clause, so before signing, it’s important to ask for a product without prepayment fees. Alternative lenders frequently offer small business loans and lines of credit with no prepayment penalty. These lenders typically offer loans with less paperwork and faster funding, though, compared to traditional business loans, they may come with higher rates and less flexible terms.

Whether a lender charges a prepayment fee isn’t always immediately clear from the contract. If you’re uncertain, call and ask. If you’re in New York, nonbank loan offers of up to $2.5 million must spell out the prepayment penalty in writing before you agree to the loan.

Calculating Prepayment Fees

Lenders have different methods for calculating prepayment fees. Often the fee is calculated as a percentage of the outstanding balance, or 1% - 5% of the outstanding balance. For instance, if you had a $100,000 loan with a 4% prepayment penalty, you would pay $4,000 when you paid off the entire loan. Other lenders may charge a prepayment penalty equivalent to the interest on a certain number of months.

Prepayment penalty clauses vary from contract to contract. Sometimes a penalty is triggered if you pay the loan balance completely. Some loans, however, will trigger the penalty fee if you pay off a large part of the loan but not the entire amount.

If you take out a 15-year or longer SBA 7(a) loan, you’ll pay a prepayment penalty if you voluntarily prepay more than 25% of the balance during the first three years of the term. You will not have to pay a fee if you exceed the 25% limit with regular payments. If the prepayment penalty is on the contract, the fee is 5% of the amount prepaid during the first year, 3% the second year and 1% the third year. Penalty fees are also not charged after the first three years.

Some prepayment penalties shrink over time. That means the later you pay off the loan in the first few years, the less you’ll pay in prepayment fees. After the loan contract’s “time window” is up, you can pay off the balance completely without triggering a prepayment fee. SBA 504 loans have a prepayment penalty through the first half of their term. With a SBA 504 loan, the prepayment penalty is based on the debenture rate, not the all-in rate. Moreover, if a buyer buys your property and assumes the SBA 504 loan, you won’t have to pay a prepayment penalty. Some commercial real estate lenders even have a lockout period in which the borrower can’t prepay any amount of the loan at all. After the lockout ends, prepayment penalties often decrease the longer the borrower waits to pay off the loan.

Commercial mortgage-backed securities and other types of commercial real estate loans may come with a prepayment penalty in the form of a defeasance clause. Defeasance clauses stipulate that you can’t pay off the full balance without also replacing the current property with collateral the bank approves. The new form of security often means that you pledge a fixed income investment such as a treasury bond.

Merchant cash advances, or MCAs, have a factor rate rather than an interest rate. The factor rate fixes the total payback amount when you sign for the cash advance. That means you’re on hook for that total amount even if you pay back the loan early. The only exception is if the funder agrees to an early payoff discount. When you get the offer, look for the term that says “discount.”

Worth Paying Off the Loan

To see if you’ll save money by paying the loan off early, figure out how much you’ll pay in prepayment fees. Calculate what you would pay in additional interest payments if you kept the loan. If the interest payments are more than the prepayment fees, it’s worth paying off the loan and cutting interest charges. Conversely, if the penalty outweighs the amount you’d save on interest, you’ll want to wait until the penalty-free time frame opens. Always call your lender to check what triggers the prepayment penalty. You may simply need to wait a year or two before paying the loan off.

Once the loan is paid in full, send your lender a signed statement requesting a UCC termination statement. Your lender must file the UCC termination within 20 days. If it doesn’t, it can be liable for $500 in addition to your actual losses from the failure to terminate.