What Is a Prepayment Penalty? | Business Lending Glossary
A prepayment penalty is a fee for paying off a loan early. Learn when it applies and how to calculate if early payoff still makes sense.
Definition
A fee charged by a lender when a borrower pays off a loan before its scheduled maturity date.
Explanation
Lenders earn revenue from interest over the loan's life; early payoff reduces that revenue. Prepayment penalties compensate lenders for lost interest. They are common in SBA loans, commercial real estate, and some term loans. Structures vary — flat percentages of remaining balance, step-down schedules (e.g., 5-4-3-2-1% by year), or "make-whole" provisions that reimburse the lender for the full interest stream.
Example
A business repays a 5-year term loan in year 2, triggering a 3% prepayment penalty on the $300,000 remaining balance — a $9,000 fee that partially offsets the interest savings from early payoff.
Why It Matters
Prepayment penalties can make refinancing to a lower rate financially counterproductive — always calculate the net benefit after accounting for any penalty before prepaying or refinancing a loan.
Frequently asked questions
Do all business loans have prepayment penalties?
No — many online lenders and lines of credit have no prepayment penalty, while SBA loans and commercial real estate loans commonly do. Always check the prepayment clause before signing any loan agreement.
