Being in debt is stressful. Nobody wants to stay in debt longer than they have to –with the subsequent interest it implies, so it makes sense that you might try to pay off your debts as quickly as you possibly can. Just have in mind that doing so may involve a prepayment penalty.
If you’ve borrowed money, you would think you’d be able to make additional payments towards your debt whenever you want right? After all, your lender should be happy that you’re paying off your debt quickly as it means they don’t have to worry about losing the money they advanced you.
But, to a lot of business owners’ surprise, this isn’t always the case. Oftentimes, lenders charge a prepayment penalty — that is, a fee for making early or supplemental loan payments.
So, why do banks charge a prepayment penalty?
Let’s take a look at the reasons for prepayment penalties and how much these fees usually are.
What is a Prepayment Penalty & Why Do Banks Charge It?
What exactly is a prepayment penalty?
A prepayment penalty, also referred to as an early payoff penalty, is just what it sounds like — a fee banks charge if you pay off your debt ahead of schedule. If your loan contract has a prepayment penalty clause, then you won’t be able to make early or additional payments without being charged a fee.
Generally, prepayment penalties are a percentage of your remaining balance. Or, in some cases, the fee may be equal to a certain number of months’ worth of interest.
Fees like this are why it’s so important to review your loan terms before signing anything. You don’t want to end up having to pay thousands of dollars in fees unexpectedly.
Why Banks Charge Prepayment Penalties
If you’re like most borrowers, you’re probably wondering why a bank would penalize you for being a responsible borrower.
A lender’s biggest concern is that a borrower might not be able to pay off the entirety of their debt, so why punish someone for going above and beyond with their monthly payments?
Well, like a lot of things, the answer has to do with money. Lenders make most of their money from interest. When you pay off your loan sooner than expected, your lender doesn’t earn as much interest as expected.
For example, say you take out a $50,000 loan with a four-year term to pay for new equipment for your business. Your loan has a monthly interest rate of 2%. That means over the course of four years, you’ll have to pay $36,303 in interests. However, over the course of the first year, your business does much better than expected and you are able to repay the loan in full.
In this scenario, your lender would miss out on four years worth of interest! That’s a big chunk of the total $36,303 you would have ended up paying in interests.
To remedy this, banks charge prepayment penalty fees to discourage borrowers from paying off their debts early or to make up for the lost interest in case the borrower still decides to make early payments.
How Much is a Prepayment Penalty?
Depending on how much your prepayment penalty is, you could still end up saving money on interest.
So that begs the question, how much is the average prepayment penalty?
Unfortunately, there is no standard rate for prepayment penalties. It depends entirely on your lender and the type of loan you are taking out. So it’s important to carefully review your loan terms to understand what penalties you might face for making early payments.
The SBA, for example, doesn’t charge any interest on its popular 7(a) loans as long as the term is less than 15 years.
However, SBA 7(a) loans with terms longer than 15 years do carry a penalty if you pay off your loan within the first three years. In this case, you would have to pay 5%, 3%, then 1% of the amount you prepaid during the first three years of the loan term.
Alternatively, your lender might charge a prepayment fee as a percentage of your interest payments.
For example, a lender could establish a prepayment fee equal to 75% of six months’ worth of interest. This type of penalty is particularly common with mortgages.
To calculate this, you would have to determine what your interest-only payment is every month, multiply that number by six, then by 75%.
Or, your lender might charge 5% of the balance of your loan as the prepayment fee.
As you can see, there are several possibilities. That’s why it’s important that before you decide to go ahead and make those early payments, learn how your prepayment fee is calculated. That way you can determine whether or not it’s worth the money you’ll save on interest.
Other Penalties & Fees Imposed by Lenders
Prepayment penalties aren’t the only hidden fees to watch out for.
Lenders often write a variety of fees into loan contract that you should be sure to watch out for, including:
- Origination fees
- Third-party fees
- Processing fees
- Maintenance fees
- Late payment fees
Some lenders will even charge fees depending on the type of payment you use in order to incentivize you to use their preferred payment method. For example, I’ve been charged a fee for making a loan payment via check.
Often, these fees are insignificant on their own. For making a loan payment by check, I was charged a modest $10 flat fee.
But these fees can add up over time. That small $10 fee could turn into hundreds of dollars if I continue using checks to make my loan monthly payments over a multi-year term. And that doesn’t even account for other fees I could incur.
So, again, be sure to review your loan contract carefully to ensure that you are completely aware of any and all fees that you may be charged in the future.
What Can You Do to Avoid a Prepayment Penalty Fee?
If avoiding prepayment penalties is a major concern for you, then you have two options: either don’t take out a loan with a prepayment penalty clause or you stick to the agreed loan term and avoid making early payments.
But, if you do take out a loan with a prepayment penalty, there are a few factors you should consider.
First, if the prepayment fee is less than what you would end up paying in interest, then it might be best to go ahead and pay off your loan early as it would save you the most money in the long run.
You should also consider what else you could do with your spare funds aside from making additional loan payments. Think that you could use that extra money to invest in new business equipment, purchase inventory, finance a new marketing strategy or hire new staff, among others.
You may find that investing your extra money back into your business is a better idea than paying off your loan early.
Lastly, if your lender offers you a loan with a prepayment penalty, ask for a new quote without a prepayment fee. Your lender may be able to negotiate different terms. In any case, you’ll never know if you don’t try.
Camino Financial: Business Loans With No Prepayment Penalties & No Hidden Fees
Nobody wants to deal with hidden fees. Prepayment penalties and other fees can add up over time and make it more difficult to get out of debt.
That’s why, at Camino Financial, we do everything we can to minimize the total cost of your business loan. This means no prepayment penalties or any other hidden fees. You can pay off the total amount of your loan at any time if you decide so. It’s that easy and transparent. The only fee involved in our business loans is a one-time closing fee that ranges from 5% to 6.99% of the loan amount.
Want to see for yourself how affordable our loans are? Use our business loan calculator to see how much your loan would cost.
Want more information on how to save money on a potential loan? Keep reading: Save on Business Loan Fees and Invest Your Money Wisely.