Prepayment Penalty
Definition
A prepayment penalty is a fee charged by a lender when a borrower pays off a loan before its scheduled maturity date. Prepayment penalties compensate the lender for the interest income they lose when a loan is repaid early. These penalties can be structured as a percentage of the remaining balance (1–5%), a set number of months' interest, or a declining scale (higher penalty in year 1, lower in subsequent years). SBA loans have specific prepayment penalty rules — 7(a) loans over $25,000 with terms of 15+ years have a prepayment penalty during the first 3 years. Many online lenders and MCA providers do not charge prepayment penalties.
Example
A business has a $300,000 commercial loan with a 3% prepayment penalty in years 1–3 and 1% in years 4–5. If they refinance after 2 years with $250,000 remaining, the penalty is $7,500. They must factor this cost into their refinancing decision.
Related Terms
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