When we’re in debt, it’s often our first reaction to try to get rid of that debt as quickly as possible. However, that’s not always the best financial decision for a small business, or even a possibility with the loan you’ve received. Before you decide to try to pay off a business loan early, take the following points into consideration.
What is a Prepayment Penalty?
In many loan agreements, you’ll find the term “prepayment penalty.” Basically, this means that you’ll be charged penalty fees if you pay down or pay off your loan balance within a certain period of time, before the agreed upon schedule.
You’re probably asking why prepayment penalties exist. After all, don’t lenders want their money back sooner rather than later? The answer is usually no. Lenders make their profit from the interest they charge. When you repay a loan early, the lender loses out on those extra months of interest. A penalty is their way of recouping that lost interest.
Some Small Business Loans Have Prepayment Penalties
Before deciding if you want to pay off a business loan early, you’ll want to take a look at your loan terms to find out if that’s a possibility. There are several types of loans that typically include terms about this type of penalty. For small business owners, two of the most common will be traditional term loans and some SBA loans.
• Traditional Term Loans: These loans typically have prepayment penalties because they’re built with a set number of payments and a set amount for each of those payments, with a fixed interest rate built-in. With relatively payment periods, a recipient paying early would result in the loss of a great deal of interest for the lender.
• SBA Loans: The most common SBA loan is the SBA 7(a) loan. If your loan has a term of under 15 years, you won’t face prepayment penalties. If your loan term is 15 years or over, you’ll have to pay a penalty if you pay the loan off in the first three years.
Short term loans are another common option for small business owners. With these types of loans, you typically won’t see a prepayment penalty, but you also won’t be off the hook for interest, even if you pay off your loan early.
• Short Term Loans: With these loans, lenders will add in a factor rate, rather than specifying interest as a percentage. That means that your interest will be locked in with your monthly payments. Even if you pay off your loan ahead of schedule, you’ll be paying the same amount in interest that you would over a longer period of time.
Pay Attention to Amortization
Unlike the loans listed above, amortizing loans typically won’t come with a prepayment penalty. The reason for that is these loan payments are based on an amortization schedule. According to that schedule, the payments you make at the beginning of your payment period will be put toward interest. Over time, those payments will go toward paying down the principle. If you choose to pay off this business loan early, you’ll save money on interest in the long run, but lenders won’t be missing out on large sums of money.
Consider Your Cash Flow, Taxes, and Credit
After examining the terms of your loan and determining if it’s possible to pay off your business loan early, take a look at how your two options will affect your cash flow. If you’re tired of high monthly payments with sizeable interest rates every month and you have the influx of cash to cover the remaining amount, it might be worth it to pay off the loan early.
If you find that your business has a few extra profitable months in a row, it will be tempting to pay off loans and be done with that debt. Think carefully before making that decision. If your sales decrease in the coming months and an emergency expense comes up, will you have the cash reserves to handle it? If not, that lump sum payment may be better left in your budget while you make monthly payments and keep a cash reserve.
Another reason to consider paying off your loan early is to get more credit elsewhere. With your current loan, your business will be carrying a debt. By paying that off, your income to debt ratio will look more attraction to potential lenders. With that improved ratio and without an outstanding debt, you’ll have a greater chance of securing another loan to help your business grow.
Finally, don’t forget to factor taxes into your plan as well. Remember that any interest paid on small business loans throughout the year can be listed as deductions when filing your business taxes. By repaying your loan early, you could be missing out on that deduction. You can learn more about the deductions you’re eligible for at the IRS official website.
Should You Pay Off Your Business Loan Early?
Ultimately, the decision of whether to pay off your loan early or to continue making regular payments is one that will depend on the unique circumstances of your business. Consider the points above to help with that important decision. Click here to learn more about the funding options we offer.
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