If you decide to pay your business loan off early, this could benefit you in a number of ways. However, you aren’t always guaranteed to make savings if you prepay instalments or terminate your contract altogether. To help you make the best decision for you and your business, this guide outlines the various pros and cons associated with early payment and offers advice on how to calculate your potential gains or losses. Finally, to clear up any potential confusion, we conclude by answering some frequently asked questions.
Frequently in business, you need to take on a little debt to get ahead. However, while business loans are an indispensable tool for small to medium-sized enterprises (SMEs), regular interest payments can burden your cash flow in the long term. Therefore, if your business has currently got enough cash on hand to get ahead of its repayments, it might be tempting to do so.
Depending on your chosen solution and lender, this could save your business money and spare you unnecessary anxiety. However, loan prepayments aren’t always guaranteed to save you money. In fact, in certain cases, submitting payments prematurely and terminating your loan could leave you in a worse financial situation than you were in before.
To help you decide if this is the right course of action for your business, this article breaks down the pros and cons of paying your business loan back early. We also help you calculate how much you could stand to gain or lose from early repayment, so you’re able to make the smartest financial decisions possible.
WHAT IS A LOAN PREPAYMENT?
When you sign a loan contract with a lender, your agreement is typically expected to last for a specific amount of time. This means there is generally a fixed end date for the repayment of the loan. Loan prepayments occur when borrowers pay back a bill or settle a debt ahead of its original due date.
For businesses that pursue funding, prepayment can be a useful way to resolve their debts ahead of time. However, while a wide range of solutions in traditional and alternative financing accept the practice, many disincentivise businesses from making payments early.
To learn more about the risks involved with premature loan repayments, here are some common benefits and drawbacks associated with the practice.
WHAT ARE THE BENEFITS OF PREPAYING LOANS?
Saves you on interest payments
No matter what kind of funding your business chooses, odds are you’re being charged interest on top. Interest payments make borrowing possible by allowing business owners to spread loan payments over an extended period of time. However, while interest payments dwarf in relation to most loans repayments, their cost can add up over time.
Due to these mounting costs, regular interest payments can be a large expense for many small businesses—especially those taking out high-interest solutions or longer-term business loans that last for a decade or longer. With this in mind, if your business has the funds spare to repay its debts, it makes logical sense to stop paying unnecessary interest sooner rather than later.
Greater financial freedom
Loans open up a lot of doors for small business owners. Despite this, once an SME agrees to loan contracts, its financial freedom can become limited. Not only are you tied to monthly repayments and interest charges, but you may also be restricted from spending your money in the way you choose. Therefore, by paying your loans off early, you can invest your funds into areas of your business and have complete autonomy over your finances.
In certain cases, prepaying your loan could also benefit your reputation as a borrower. When lenders assess your credibility, they take note of your debt-to-income (DTI) ratio. This represents the percentage of your income that is allocated towards debt repayments. If businesses pay off loans early, their debt-to-income ratio improves. This makes it more likely for them to be approved for funding in the future.
Peace of mind
Being in debt can take its toll. While it's a useful way to advance the growth of budding businesses, it can often loom over the heads of business owners. Not only are there the routine anxieties associated with keeping on top of regular payments, but being indebted can also trigger feelings of shame and a lack of control. Therefore, as a general rule of thumb, the less debt your company has, the greater peace of mind you'll be able to achieve.
With this in mind, if your business is able to pay off quickly, it may be worth doing so. However, if your business’s debts are weighing on your mental health and early repayments are out of the question, it’s always worth talking to your lender to discuss reasonable adjustments.
As you can see, paying your loan back early has the potential to benefit your bank balance and mental state. Unfortunately, the advantages of prepayment aren't always so clear-cut.
Next, we discuss some potential drawbacks involved with the practice.
WHAT ARE THE DRAWBACKS OF PREPAYMENT?
Interest payments are the bread and butter of loan providers. Therefore, most lenders don't want borrowers to pay their loan back earlier than the agreed-upon due date. To deter them from doing so, many loan providers issue prepayment penalties to businesses that pay their instalments in advance. Otherwise known as an early payoff penalty, this penalty can vary in amount but is typically a percentage of your loan's remaining balance.
Not all lenders will issue this fee, and it won't be attached to every solution. However, to avoid getting caught out, business owners should always read the small print of their loan agreement before agreeing to its terms.
Early termination fees
Unfortunately, prepayment penalties aren’t the only fees business owners can be lumped with if they decide to rid their debts ahead of time. If borrowers attempt to cancel the loan altogether, they could be faced with an early termination fee.
Also known as a ‘breakup fee’, this charge is put in place for a similar reason as prepayment penalties. Cancelling a loan early can cost a lender, so by charging this fee, they deter borrowers from terminating an agreement early, and they’re able to cover their losses if they do. Only certain lenders charge termination fees, so if you’re considering bringing your loan to an end before its due date, you should only pursue loans that won’t penalise this action.
Harder to improve credit score
Many business owners assume that paying off their debts early will benefit their credit score. Surprisingly, this isn’t always the case. Paying off business loans early isn’t like paying off credit card debt. In many cases, the more you make regular, timely payments to your lender, the more you’re able to improve your credit profile. In fact, many business owners take out loans with the sole intention of improving their reputation as a borrower.
Alternatively, if you reduce your credit utilisation by prepaying or cancelling your loan, your credit score could suffer as a result. To avoid this from happening, you should research how prepaying your loan could impact your business’s credit profile.
Savings aren’t guaranteed on all solutions
As we’ve already covered, advancing your loan payments could free up your cash flow and grant you greater financial freedom. However, while this is true with loans that charge interest, it isn’t the case with all solutions.
Some loans determine their fees with factor rates instead of interest rates. This means they are tied to a fixed amount of fees that normally equal to a certain percentage of the loan. If you pay back these loans early, you aren’t able to make any savings on interest. Therefore, it isn’t always financially wise to pay off your debts early.
Factor rates are most commonly used in short-term financing options like merchant cash advances. So if you’re using this form of funding, it’s worth checking the terms and conditions of your agreement before you consider paying your instalments early.
IS IT WORTH IT? HERE’S HOW TO DECIDE
Deciding when to pay back your loan isn’t always an easy decision. By understanding the rewards and risks involved with prepaying, you should be able to make a more informed decision.
Ultimately, if your chosen solution charges additional interest and doesn't feature any prepayment penalties, it's likely you're going to save money by paying your instalments early. On the contrary, if your lender tries to disincentivise early payments by burdening you with prepayment or early termination fees, there's a chance ending your loan prematurely could put you out of pocket.
If you want to work out how much you could stand to gain or lose, you can follow these three steps.
- Calculate how much interest you would be paying from now until the end of your loan period, taking into account the type of interest you are being charged.
- If applicable, add up any prepayment or early termination fees you will be charged if you cancel your loan early.
- Subtract these prepayment and early termination fees from your calculated interest payments.
If your figure is positive, it’s likely that you’ll save money by paying your loan back early.
SELECT YOUR LENDER WISELY
Paying your loan back early is a tempting proposition for many business owners. By weighing up the pros and cons above and calculating your potential savings, you can decide whether or not it’s a good idea for your business.
As we've addressed, this decision will largely depend on the nature of your loan. For instance, if you're locked into a loan with strict stipulations and penalty charges, you won't be as free to pay back your debts when you wish. For this reason, when scanning the market for solutions, it's recommended that you consider options with no early repayment fees. This way, you can borrow capital to take your business to the next level without being bound to long term interest payments.
Here at Kriya, we don’t believe in early payment fees. This means you’ll be able to settle our flexible solutions at a time that suits you, without incurring any additional charges. If you’re interested in funding your SMEs future ambitions with Kriya, you can find out more about our financing options here.
FREQUENTLY ASKED QUESTIONS (FAQS)
What is a loan prepayment? Loan prepayments refer to when borrowers pay back a bill or settle a debt ahead of its original due date. For businesses that pursue funding, prepayment can be a useful way to resolve their debts ahead of time. However, while a wide range of solutions in traditional and alternative financing accept the practice, many disincentivise businesses from making payments early.
What are the pros of paying your business loan back early? Business owners can benefit from paying their loans back prematurely in a number of ways. They may be able to save money on interest payments, gain more financial autonomy and improve their reputation as a borrower, and finally, improve their peace of mind.
What are the cons of paying your business loan back early? If business owners decide to pay their business loan back early, they may face prepayment or early termination fees from the lender. What's more, if they are relying on certain solutions like merchant cash advances, they may not be able to make any savings on interest, and it also may be harder for them to make improvements to their business's credit score.
What is a prepayment fee? Prepayment fees are charges lenders impose on borrowers who pay their loan instalments early. Otherwise known as an early payoff penalty, this penalty can vary in amount but is typically a percentage of your loan's remaining balance. Not all lenders charge for an early prepayment, but it's a common practice in the alternative finance world.
How do you calculate if you’d save money by prepaying your business loan? To work out how much money you'd save by paying your business loan back early, you just need to follow three simple steps. First, you calculate how much interest you'd be paying from now until the end of the contract; then, you total any fees you'd be charged from prepaying your loan or cancelling it altogether. Finally, you subtract the latter figure from the former, and if this result is positive, you'll save money from paying your loan back early.