A prepayment penalty is a fee that a lender can charge if you pay off or pay down a loan by a certain amount before a specified date. In order for a lender to charge a prepayment penalty, it must be disclosed upfront in its loan agreement. It must also specify the specific conditions in which it will be applied and how it will be calculated.
As a borrower, it’s important to read the terms of your loan agreement before signing anything, as this can help avoid unexpected fees such as a prepayment penalty. Since prepayment penalties are meant in part to discourage a loan from being paid off early, this can mean that you may be stuck with a loan payment for longer than you might want.
How a loan prepayment penalty works
A loan prepayment penalty typically has two major elements. Firstly, it will have a time component that stipulates when the prepayment penalty can be assessed. Secondly, it will have a specific methodology as to how the prepayment penalty is determined and how it will be calculated.
Time element
If a loan has a prepayment penalty, the lender must specify when it will apply. The most common scenarios are when a loan is paid off before a specific date or when the loan balance falls below a certain threshold before a certain date.
- Loan pay off: When a loan is issued, it generally has a maturity date — the date when the loan will be paid off if all regularly scheduled payments are completed in a timely manner. Prepayment penalties can apply if the loan is paid off at any point prior to the maturity date. For example, a lender may choose to charge a prepayment penalty if a loan is paid off within five years of the loan origination date.
- Loan balance: Even if a loan is not completely paid off, a lender can assess a prepayment penalty if a significant portion of the loan is paid by a specific date. For example, a lender may state that a prepayment penalty will apply if more than 25% of the principal balance of the loan is paid off within three years of the loan origination date.
Methodology for determining the amount of the prepayment penalty
Although a prepayment penalty can be calculated in several different ways, a lender must disclose how it will be calculated when it issues you the initial loan agreement. Below are some common ways a prepayment penalty can be calculated:
- Flat fee: Perhaps the simplest calculation method, a flat dollar amount can be charged as a prepayment penalty.
- Percent of remaining balance: A more common way to calculate a prepayment penalty is based on a percentage of your current remaining loan balance. For example, a 4% prepayment penalty on a loan balance of $100,000 would result in a $4,000 fee being added to the loan pay off amount.
- Amount of interest paid: Another method that can be used to determine the amount of a prepayment penalty is figuring out how much interest would have been paid if you made the minimum regular payments, and comparing it to how much interest you’ve paid on the loan so far. The difference between these two figures will then be the amount you’ll have to pay in additional interest charges.
- Graduated fee: Finally, some loans charge a smaller prepayment penalty the longer you’ve had the loan. For example, a loan may stipulate that you’ll pay a 5% prepayment penalty based on the outstanding loan balance but that it will be reduced by 1% for each year that the loan is not paid off.
How a loan prepayment penalty affects borrowers & lenders
At first glance, a loan prepayment penalty is something that only benefits lenders, guaranteeing a minimum amount of interest or fees they’ll receive. However, a prepayment penalty’s impact on a loan can also have some positive benefits for borrowers.
Lenders
When a lender charges a prepayment penalty on a loan, it essentially guarantees that it will earn a minimum amount of interest revenue on it.
Interest charges are a big source of revenue for most lenders, so it’s usually in the lender’s best interest to have its borrowers keep paying on its loans for as long as possible. Loans with no prepayment penalty, by comparison, could be paid off the very next day by the borrower, something that would result in virtually no interest earnings for the lender.
Borrowers
As a borrower, one of the few positive benefits is that a loan that carries a prepayment penalty may allow you to get better rates and terms. However, most other aspects of a prepayment penalty have a negative impact. You could be locked into having a loan payment for the long term, something that could hinder your company’s cash flow and its ability to invest in other areas of the business.
Depending on how the prepayment penalty is calculated, you could have less of an ability to save money on interest charges by paying off the loan early. Finally, it could make it more difficult to refinance the loan if the costs of paying the prepayment penalty outweigh the potential benefits of the refinance.
When to accept a loan with a prepayment penalty
As a borrower, getting a small business loan with a prepayment penalty may seem counterintuitive, considering all of the cons associated with it. However, it could still be a good fit for you if the following circumstances apply:
- You have no plans on paying off the loan early: Worrying about a prepayment penalty becomes a moot point if you don’t anticipate refinancing the loan or otherwise paying it off prior to the maturity date.
- You are unable to get a loan with similar terms: You might have to accept a loan that carries a prepayment penalty if you’re seeking loan terms that not many lenders offer. You might also not have much of a choice if you’re having trouble getting approved for financing.
- You can get a competitive interest rate: Loans with prepayment penalties can sometimes offer more competitive rates. If you find this is the case, consider how likely it is that you might want to pay off the loan early, as well as the costs associated with it. If you don’t think you’re likely to trigger the prepayment penalty, you can take advantage of a more competitive interest rate.
When to pay off a loan with a prepayment penalty
Incurring fees associated with a prepayment penalty might not be ideal, but it can be the right thing to do if the following apply to you:
- Your savings would exceed the fees: This is the lesser of two evils, but if paying off the loan means that you’d still save money in interest charges even after the prepayment penalty is factored in, it would make sense to go ahead and do so.
- You need the extra cash flow: Paying off the loan can help you qualify for other means of funding or other loan sources, as other lenders would see fewer debt payments and, therefore, a greater capacity to handle additional loans. In other words, if the benefits you’d get from fixing cash flow problems are something that would exceed the financial loss of having to pay the prepayment penalty, you should pay off the loan.
- You’re looking to prioritize debt reduction: If you’re not prioritizing monetary benefits but rather just want to simplify your finances, paying off the loan early can also be an acceptable reason to simply eat the cost of the prepayment penalty.
Frequently asked questions (FAQs)
Almost any type of loan can have a prepayment penalty. However, it’s most common with loans that have high upfront closing costs, such as home loans, commercial real estate loans, and SBA loans. Regardless of the type of loan you’re getting, you should read your loan agreement to determine whether a prepayment penalty applies.
In general, a prepayment penalty can range from 1% to 5% of the remaining loan amount. However, the calculation methodology can vary depending on the lender, loan amount, and loan type.
The easiest way to avoid a prepayment penalty is to not accept a loan that has one. If you’ve been approved for a loan but have not yet accepted, you may be able to negotiate this with the lender. If you currently have a loan with a prepayment penalty, however, you’ll most likely have to pay it, although you can ask your lender to see if they would be willing to waive or reduce the penalty amount as a credit policy exception.
Bottom line
If you think you might want to pay down or pay off a loan before its maturity date, check to see whether the loan charges a prepayment penalty. Prepayment penalties may apply if you pay down a significant amount of the loan, refinance to another lender, or otherwise pay off the balance of the loan early.
While a prepayment penalty can make it more difficult to save money by paying off a loan more quickly, loans that carry a prepayment penalty can also sometimes offer more competitive rates upfront.
