Prepayment penalties and paying off early

Most borrowers assume that paying a loan off early saves interest. For a conventional amortising loan it usually does. For several products commonly sold to small businesses, it does not, and the difference is worth thousands.

The three structures

Simple interest, no penalty

Interest accrues on the outstanding balance. Pay early, pay less. This is what most people assume they have, and for many bank term loans it is correct.

Simple interest with a prepayment penalty

You save the interest but pay a fee for the privilege. The fee may be a percentage of the balance, a set number of months of interest, or a figure that steps down over the life of the loan. Whether early repayment still pays depends on the arithmetic.

Fixed total repayment

You owe a set total regardless of when you pay. Common where cost is expressed as a factor rate — merchant cash advances, some short-term products. Repaying in six months rather than twelve costs exactly the same, which means the effective annualised cost of early repayment is enormous.

Why penalties exist

A lender priced the loan expecting a certain return over a certain period. Early repayment removes that, and on a fixed-rate loan funded at a particular cost it can genuinely leave them out of pocket. That is a legitimate reason for a penalty, and it is more common on longer fixed-rate and real estate lending than on short working capital facilities.

It is worth distinguishing that from a fixed total repayment, which is not compensating for anything — it is simply how the product is priced.

Where it bites

• Refinancing into something cheaper. The penalty eats part or all of the saving, and needs to be in the calculation.
• Selling the business. A buyer or a payoff at closing triggers it, sometimes at an inconvenient moment.
• A windfall. A big contract or an asset sale that would let you clear debt may not be worth using for that.
• Graduating to a bank facility. The healthy outcome, made expensive by a clause signed when you had less choice.

What to ask before signing

1. Is there a prepayment penalty, and how is it calculated?
2. Does it step down over time, and on what schedule?
3. What exactly would settlement cost at twelve months, and at twenty-four? Ask for the figures, not the formula.
4. Is any part of the interest earned upfront regardless of timing?
5. Is there a window where repayment is free — many loans allow prepayment after a certain point without charge.

The comparison this changes

Two offers can look nearly identical and behave completely differently. A slightly higher rate with no prepayment penalty is often better than a lower rate with a stiff one, particularly for a business likely to refinance as it strengthens.

That is exactly the situation of most growing businesses using non-bank credit. You take the expensive money because it is available, you improve, and then you want out. A loan that makes leaving costly has priced in your success at your expense.