Prepayment Penalties: Managing Business Loan Terms

Prepayment penalties are assessed against borrowers who pay off their loan before it matures. For many businesses, this will occur after a large sale or when profits stabilize. For others, this will occur when they seek to refinance or modify the loan in another way. In any case, it is important to consider the cost of prepayment before you decide to exit a loan early. It is best to consider these terms long before the event actually arises. If you can think ahead when you are at the negotiating table singing your initial loan, you will benefit in the long run.

Balance Interest Rates Against Terms

When your business is considering which loan to choose, consider the options against all terms. It is easy to focus on interest rate alone. Interest rate will be the primary factor in how expensive your business loan ultimately is. However, other terms play a crucial role down the line. Keeping this long-term perspective in mind will ensure you do not make a hasty decision on a loan that will affect the future of your business when you are still in your infancy. The goal is to pay off your initial start-up loans quickly so you can seek additional financing when it is time to expand. These expansion loans may have longer payment terms, but you want to get your business into the black as early as possible by paying off your start up loans quickly. 

Use Terms as a Factor in Negotiation

Negotiating loans is difficult for many inexperienced borrowers. Lenders expect you to negotiate on key points, however, and loan terms are a great place to start asserting your business needs. Agreeing to higher prepayment penalties may result in a lower interest rate from the start. If you can secure a low interest rate in the beginning, the need to refinance is less of a threat to the lender. Ultimately, no borrower wants to modify a loan. Modification is only pursued when the loan terms are not good enough for the borrower. Getting better terms at the beginning will reduce the probability you will have to modify the loan in the future. 

Manage Monthly Payments

Many borrowers make the mistake of thinking overpaying each month is a good strategy in borrowing. In fact, the opposite is often true. Paying too much each month may mean you pay off your loan early without even realizing you have made the error. You will have to pay the prepayment fees regardless of whether you end the loan early with a lump sum or with high monthly payments. Manage your monthly payments with an automatic debit from your company account in order to assure they are made on time and in the correct amount.

Weigh Cost of Penalties when Prepaying

If your business does decide you need to pay off your loan early, either to refinance or simply get out of debt, it is important to weight the negatives against the money you will save in paying off the loan. This means you should consider both the prepayment fees and the effect this will have on your business's credit score. When you modify a loan, you credit will go down. Only prepay if you stand to save enough money to compensate for the funds you lose in fees as well as the softer damage of reduced credit.