Repaying a business loan early may seem like an attractive option in certain situations. Depending on the business lender and loan type, prepayment may save you money on interest. Additionally, many business owners seek the additional flexibility and control over their cash flow that comes with loan prepayment options.
However, before prepaying an existing loan or taking out a new loan with a prepayment option, it’s important to consider whether it makes sense for your business. Read on for some business use cases when you’ll want to consider prepayment, and when you might not.
When Does it Makes Sense to Prepay a Loan?
When thinking about prepaying a loan, it’s important to consider whether it’s the right option for your business and its cash flow needs.
For example, if your business has a fluctuating sales cycle (i.e., construction, restaurants, retail), paying off your business loan early can be beneficial. If you pay off the loan after your most lucrative sales period, you can avoid carrying a loan payment during “leaner” months. Doing this will require that you have enough cash on hand after paying off the loan to last until your next busy season, so it’s important to carefully analyze your projected cash flow needs before considering this option.
Another scenario where it may make sense to pay back a loan early is if your business has become more successful than you expected when you first took out the loan. If you find you have more cash on hand than initially projected, it may save you money to prepay, particularly if your lender will waive remaining interest payments. Not all lenders will waive interest payments, so when looking for new financing make sure that prepayment conditions are one of the metrics you ask your lender about.
When Does it Not Make Sense to Prepay a Loan?
Of course, there was a reason you sought financing in the first place; after all, if you had the cash flow, you wouldn’t have needed to take out a loan. Before deciding to prepay, think back to the specific business reason you identified to take out the loan. Do you feel like you have truly met these goals under budget and ahead of schedule, and with the ability to pay off the remaining loan balance in a lump sum? If not, you may find it makes more sense to “stay the course” of the original financing plan you set out, and continue to pay the loan as scheduled.
For example, there may be subsequent business use cases related to your original goal that you can use the money for. If you took financing originally to open a new location, spreading the loan expense across the full payment schedule may allow you to continue to invest in small improvements in your new location, extend business hours for your busy season, or buy more inventory, since you have access to the capital over a longer period of time.
In this case, you may want to consider using the extra runway with funds to grow your business, and pay your loan as originally scheduled.
How to Evaluate Prepayment Options on a New or Existing Loan
If you’ve decided it makes sense to either prepay an existing loan or get a new loan with a prepayment option, you’ll want to be sure to read the fine print first. While the flexibility to pay off debt when it works for your business can be a great way to reduce interest payments and eliminate the cash flow burden of a periodic payment, you’ll want to make sure it financially benefits you to prepay. Here are a few questions to answer first:
Does the loan include a prepayment penalty?
Make sure your loan doesn’t include a prepayment penalty. Some online lenders have moved away from prepayment fees, but many traditional lending institutions tend to still include them (think about it: the lender is now missing out on income from your interest payments). SBA loans in particular usually come with a prepayment penalty clause.
What is the payment structure of the loan?
Once you’ve confirmed your new or existing loan does not have a prepayment penalty, you should review the payment structure, known as the amortization schedule, of your loan in detail. If the amortization is front loaded (i.e., you’re paying the bulk of the interest early on), paying off the loan early in the term could be a good idea, while paying off the loan a couple of months early won’t reap as much benefit.
With prepayment, you are not reducing the interest rate you pay, but are reducing the amount of interest you pay (provided you don’t have to pay the total interest charge and are only required to pay the balance of the loan at the time of prepayment). An amortization schedule will give this information to the borrower and he or she can calculate when it makes sense to prepay and when it doesn’t.
Will the lender waive the remaining interest?
Finally, look at whether your lender will actually waive the remaining interest payments. Many lenders will not charge you a penalty for paying your loan early, but also will not waive remaining interest payments.
Most online lenders will allow you to prepay an existing loan without a penalty. Some now also offer the ability to take out a loan with a prepayment option included. OnDeck, for example, now offers loans with prepayment options, where they waive 100% of remaining interest payments if you pay your loan off early.
When looking at a loan with prepayment options built in, be aware that these will sometimes come with higher interest rates, so if you do not exercise the prepayment option this will end up being more expensive than a regular term loan.
If you’re in the process of looking for a business loan and think it may make sense for your business to have the flexibility to pay it off early, be sure to check if this is an option. Growing and scaling a business is tough work. Business owners need to be able to adapt quickly to changes in the market. Flexible loan repayment terms can give businesses more control over their cash flow and expenses, which can be a valuable option as your company grows and your financial needs change.
Have other questions about small business loans? Check out our comprehensive guide.