Business loan prepayment penalties: What are they?

Since interest is how lenders make money, they’ll often assess fees, known as prepayment penalties, to borrowers who pay off their business loans ahead of schedule.

Although prepayment penalties don’t come with all loans, it’s important to know they exist. Not only can they influence your decision to pay off your loan early, but may also impact the overall cost of the business loan, especially for SBA and commercial real estate loans.

We’ll explore the types of small business loans that commonly have prepayment penalties, how much they are and when it may be worth paying the fee.

Key takeaways

  • Prepayment penalties are imposed by lenders when borrowers pay off a loan early.
  • SBA loans and commercial real estate loans often come with prepayment penalties.
  • Carefully reviewing loan agreements helps borrowers identify the presence of prepayment penalties.
  • Some online and alternative lenders may not have prepayment penalties.

What is a business loan prepayment penalty?

A prepayment penalty is a business loan fee charged by a lender when a borrower pays off a loan before their term ends. In addition to business loans, lenders often charge prepayment fees for mortgages and auto loans.

This penalty is typically intended to compensate the lender for the loss of interest resulting from the early payoff. Lenders often calculate this fee based on a percentage of the loan balance.

What types of business loans have prepayment penalties?

You’ll likely face prepayment penalties with certain types of SBA loans, specifically 7(a) and 504 loans and commercial real estate loans.

SBA 7(a) loans

SBA 7(a) loans, which provide financing for small businesses unable to secure a conventional loan, come with prepayment penalties; however, this is only if the term is 15 years or more. The SBA prepayment penalties typically decrease over time, and they are triggered when 25 percent or more of your loan is paid off within the first, second or third year after disbursement. Beyond three years, no prepayment penalties will be assessed.

Loan year Prepayment penalty
One year after loan disbursement 5.00% of prepayment amount
Two years after loan disbursement 3.00% of prepayment amount
Three years after loan disbursement 1.00% of prepayment amount

SBA 504 loans

SBA 504 loans, commonly used for commercial real estate projects, can also have prepayment penalties. Loan terms are typically 10, 20 or 25 years, and penalties are imposed for early payoff within 10 years or less. The penalties usually also decrease over a 10 year period, with a higher percentage in the early years, and shrink over time.

Loan year Prepayment penalty
1 3.00%
2 2.70%
3 2.40%
4 2.10%
5 1.80%
6 1.50%
7 1.20%
8 .90%
9 .60%
10 .30%
11 and up 0.00%

Commercial real estate loans

Commercial real estate loans, which are used to purchase commercial properties, are another type of business loan with prepayment penalties. Depending on the lender, if the loan is paid off in full within a certain number of years, a prepayment penalty may be imposed. However, for some lenders, how long you’ve had the loan does not matter and any early payoff triggers the prepayment penalty.

With some commercial real estate loans, a defeasance clause allows borrowers to avoid paying prepayment penalties by allowing them to replace their original collateral with a different asset.

How can you find business loans without prepayment penalties?

If you’re applying for a business loan, you should inquire with the lender directly about prepayment penalties. However, if you’re further along in the process, carefully examine loan agreements before signing.

It’s possible to avoid prepayment fees by choosing an online and alternative lender, especially if you’re applying for a short-term or fast business loan. However, it is always best to review other fees or charges associated with these loans.

When is it worth prepaying a loan?

While prepayment penalties may deter borrowers from paying off loans early, there are situations where it can benefit them to do so. Consider the following scenarios:

  • High interest rates: If the loan carries a high interest rate, the savings from early repayment may outweigh the prepayment penalty.
  • Improved cash flow: Early loan repayment can reduce monthly financial obligations and free up cash, providing more flexibility and improved cash flow.
  • Improved terms for future borrowing: Paying off a loan early may enhance creditworthiness, making it easier to secure future financing on more favorable terms.

The bottom line

As you hunt for the best business loan, it’s essential to understand the terms and conditions as well as carefully evaluate and compare your loan options to help you make an informed decision. Prepayment penalties impact your flexibility when it comes to repayment; however, there are advantages to paying off your loan early. If this is a smart move for your business, don’t let fees keep you from the benefits of early repayment.

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