What is a Prepayment Penalty on a Business Loan?
Paying off debt early is usually a smart move. But when you repay a business loan before the term ends, your lender doesn’t earn as much interest as anticipated. While most small business lenders don’t charge prepayment penalties, some will impose these fees to recoup their financial losses.
Here’s what you need to know about business loan prepayment penalties and how to avoid them — plus, learn about several lenders offering business loans with no prepayment fees.
What is a business loan prepayment penalty?
A prepayment penalty is a fee some lenders charge when you repay your loan ahead of schedule. While prepayment penalties are often seen with mortgages and auto loans, some types of business loans also impose these fees.
The prepayment fee is typically calculated as a percentage of your loan payoff amount. Your final business loan agreement should list all associated costs with repaying your loan early.
Although paying off debt early can save money, you could end up paying hundreds or thousands in prepayment fees.
Why do lenders charge prepayment penalties?
Lenders typically make their profit by collecting interest from borrowers. A prepayment penalty ensures the lender will profit from the loan even if the borrower doesn’t pay full interest.
For example, if you were to repay your loan six months before schedule, the lender would lose six months of interest income — but it could recoup some of this loss by imposing a prepayment penalty. Often, the prepayment fee drops as you get closer to your payoff date.
Types of business loans with prepayment penalties
Although it’s fairly uncommon for small business loans to have a prepayment penalty clause, SBA business loans and commercial real estate loans often come with such fees.
SBA 7(a) loans
The SBA 7(a) loan is the SBA’s most popular loan, typically used for general business expenses. This SBA loan comes with prepayment penalties if your repayment term exceeds 15 years and you voluntarily pay 25% or more of your outstanding balance within the term’s first three years.
The fee changes based on timing:
- 1st year: 5% of the amount of the prepayment
- 2nd year: 3% of the amount of the prepayment
- 3rd year: 1% of the amount of the prepayment
SBA 504 loans
SBA 504 loans are commonly used for the expansion or purchase of commercial real estate, or as a business equipment loan. These loans have prepayment penalties that decline throughout the first half of the loan term (which can be 10, 20 or 25 years).
The early payoff fee starts at 3% for the first year, dropping 0.30 percentage points every year until it reaches 0%.
Commercial real estate loans
Commercial real estate loans help business owners buy property like storefronts or office space. Traditional commercial real estate loans are similar to home mortgages since the property acts as collateral and you’ll need to make payments on a set schedule.
In some cases, your lender may impose a “lockout” period as a mortgage prepayment penalty. Once the lockout is over, the prepayment penalty for commercial loans could start at 3% to 5% of your total loan amount and decrease over time.
What is defeasance?
Prepaying commercial real estate loans, such as commercial mortgage-backed securities (CMBS loans), may require a process called defeasance.
Defeasance is when you need to replace the property with another asset as collateral to release the lien on the current real estate. In some cases, defeasance may only be available once you reach a certain point in your repayment term.
How prepayment penalties are calculated
Prepayment penalties vary by lender, but here are some common business loan prepayment penalty examples.
- Percentage of loan balance: Some lenders charge a percentage, like 1% to 5%, of the remaining loan balance if you repay the debt early or within the first few years. For example, if the prepayment penalty is 4% and you pay off a $100,000 balance, you could owe $4,000.
- Flat fee: Your loan contract could have a flat-rate prepayment fee to help the lender recoup any losses. For example, you might need to pay six months’ interest when you repay your debt early.
- Sliding scale: As with the SBA 7(a) loan above, the prepayment fee starts high and drops a bit every year. Some will cap at 1%, while others will drop to 0% after a certain time.
Business loans with no prepayment penalty
Many alternative lenders offer business loans and business lines of credit with no prepayment penalties. While these loans typically have more lenient borrower requirements and faster funding times than traditional bank or SBA loans, they often come with high business loan interest rates and inflexible terms.
Here are a few top online lenders offering business loans with no prepayment penalties.
OnDeck
| Max. amount | $250,000 |
| Term length | 24 months |
| Est. interest rate | Average rate of 60.90% APR (term loan) |
| Min. credit score | 625 |
| Min. time in business | 12 months |
| Min. annual revenue | $100,000 |
OnDeck offers short-term business loans between $5,000 and $250,000, as well as a business line of credit. Eligible borrowers can enjoy OnDeck’s prepayment benefit — pay off your loan early and all remaining interest will be waived without any fees.But while there are many things to like about OnDeck, including it being one of our top picks for a bad credit business loan, you should still be wary of high-interest rates. With the average at 60.90% APR, interest charges could add up quickly.
American Express Business Line of Credit
| Max. amount | $250,000 |
| Term length | 6, 12 or 24 months |
| Est. interest rate | 3% to 9% (6 months) 6% to 18% (12 months) 9% to 27% (18 months) |
| Min. credit score | 660 |
| Min. time in business | 12 months |
| Min. annual revenue | $36,000 |
American Express Business Line of Credit offers revolving lines of credit ranging from $2,000 to $250,000. Repayment terms are 6, 12 or 24 months, plus a monthly fee.Business lines of credit work differently than other small business loans. Once you repay what you borrowed, you can withdraw up to the limit again. The American Express Business Line of Credit won’t charge you any prepayment penalty fees for repaying your debt early.
Funding Circle
| Max. amount | $500,000 |
| Term length | 6 to 84 months |
| Est. interest rate | 11.29% to 30.12% |
| Min. credit score | 660 |
| Min. time in business | Two years |
| Min. annual revenue | No minimum |
Funding Circle provides term loans between $25,000 and $500,000 with zero prepayment penalties. If you choose to repay your loan early, you’ll only need to pay for interest incurred during your borrowing window.
With a Funding Circle business loan, your interest rate and monthly payment remain fixed for the life of your loan, making it easy to calculate early payoff amounts.
How to deal with prepayment penalties on a business loan
First, when you’re applying for a business loan, check if your business loan contract has a prepayment penalty — unfortunately, you can’t escape a prepayment clause once you’ve signed the loan agreement. If you haven’t signed the contract, ask the lender about alternative business loan products without prepayment fees.
For contracts with a prepayment clause, talk to your lender so you understand what triggers the penalty and how to avoid it. Often it’s just a matter of waiting another year or two before you can repay the debt without a prepayment fee.
If you’re determined to pay off your loan early, calculate how much you’ll save in interest. The overall savings could be worth it, even with the loan prepayment penalty.
Methodology
To appear on our list of business loans with no prepayment penalty, we selected lenders publicly stating that their loan products don’t have prepayment penalties or fees. In addition, we considered application eligibility, time to funding, interest rates and overall loan costs in creating this list.
Frequently asked questions
In general, the earlier you pay off your loan, the more you’ll save in interest. However, if your lender charges prepayment penalties and you pay off your loan early, you could pay more than if you’d stuck to the original term.
Be sure to calculate potential savings before proceeding with an early payoff, considering any prepayment penalties.
If you’re unsure if your loan has a prepayment penalty clause, ask your lender — the law requires lenders to disclose these terms. Your loan contract should have a section that covers any applicable prepayment penalties.
While paying off debt is generally a good thing, your credit score could take a temporary hit from it. Debt payoff affects your credit score, as factors like credit mix, payment history and credit utilization help determine your credit score.
However, this negative impact doesn’t last long and your score will hopefully bounce back in due time. In the meantime, follow these steps to boost your credit score after repaying debt.
If your prepayment penalty is because of an early business loan payoff and nothing else, you could potentially claim the fee and any applicable business loan interest as a small business tax deduction. That said, the Income Tax Act might not classify the payment as interest, even if you meet the criteria. Consult a tax professional to discuss your options.