Let’s say you’re a stone fabricator who normally purchases from a local supplier. You’ve heard that by going to the source in Brazil for the stone, you could save as much as 40% from buying the stone wholesale and shipping it back to the states. It’s a gamble for sure, but having a lower inventory carrying cost will surely help maximize your bottom line. Then it’s settled. You’re headed to Bahia, in the Northeast of Brazil. But now comes the difficult part, how do you get a fast business loan online to pay for the stone?
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Does My Business Loan Have a Prepayment Penalty?
Business loans from banks are great because they generally have low interest rates. However, apart from that single benefit, choosing to endure a lengthy underwriting process that can take months may ultimately mean sacrificing your opportunity to save a few bucks. A working capital business loan also known as a merchant cash advance is the fastest alternative to a bank loan.
In comparison to shopping with a bank for small business funding, you may want to let your fingers do the walking and apply online for an unsecured business loan. Keep in mind that for the speed and ease to acquire small business funding, you may pay higher interest rates and have a shorter term length to pay back the loan.
While speed and ease are definitely important to take into consideration, there are other aspects of merchant cash advances worth taking into account. For example, do you plan on paying off your merchant cash advance early? What are the advantages of paying off a merchant cash advance early? Is there a prepayment penalty on merchant cash advances? Does a merchant cash advance offer a prepayment discount to businesses that prepay their note? Read below to explore the answers to whether or not a merchant cash advance is right for your business and what prepayment penalty or prepayment discount may exist should you pay off your loan in advance.
What is a Prepayment Penalty?
Prepayment is an accounting term for the early repayment of a debt or installment loan before its official due date. Prepayments are made on loans and mortgages when an entire balance is paid off either by the debtor or the loan is refinanced by another lender at a lower interest rate. Some loans may impose a penalty for prepayment. In fact, while some loans may advertise a below-market interest rate, the loan itself may have a provision in the contract whereby the borrower is penalized for paying off the entire balance of a loan either directly or by refinancing with another bank or financing institution.
What is a Typical Prepayment Penalty?
Below is an example of a typical business loan prepayment penalty assessed by a bank. As you can see, there is a gradually declining penalty over the course of the loan period. While there is limited value in taking a loan with a prepayment penalty, it is nevertheless important to understand how the prepayment penalty may affect your ability to pay off the loan in advance and how the penalty assessed may affect the overall borrowing cost of the note. Again, it bears comparing a lower rate term loan with a prepayment penalty versus a higher interest rate one without a prepayment penalty, especially if there is a chance that you may pay off the loan in advance.
Step-Down Prepayment Penalty
The numbers below represent a percentage of the outstanding loan balance the prepayment will be. Here is an example of a $500,000 outstanding loan balance.
| Year | 1 | 2 | 3 | 4 | 5 |
| PREPAY | 5% | 4% | 3% | 2% | 1% |
| $500,000 | $25,000 | $20,000 | $15,000 | $10,000 | $5,000 |
As you can see in the above referenced example, the borrower’s penalty will be 5% of the existing loan balance, or 2% in year four.
What Types of Prepayment Penalties are there?
So, we’ve already discussed a typical prepayment penalty that a commercial bank would likely charge a borrower. Now let’s explore what other types of commercial loans may penalize a borrower with a prepayment penalty and what those fees may look like. Below, we’ll provide an overview of the most popular commercial loan products and their respective prepayment penalties:
- Merchant Cash Advance
- Equipment Leasing
- Equipment Finance Agreement
- Line of Credit
Merchant Cash Advance Prepayment Penalties
Going back to the earlier example in this article about the stone fabricator, you may recall that the business owner needed to borrow capital to purchase stone via a wholesale channel in Brazil. Given his need to act quickly to secure the inventory and lock in a great price, the business owner must secure the financing immediately. Is a prepayment penalty even an aspect of the financing that is on his radar? The answer is most likely no.
The stone fabricator’s search for a fast business loan leads him to a merchant cash advance company online. The application and subsequent approval takes less than two minutes and subsequent funding is wired into this business checking account the same day. Mission accomplished, right? Not so fast.
While the business owner was able to secure fast advance funding, and the process was seamless (completely end-to-end digital), the business owner likely failed to review the business loan agreement details.
Though it’s a common practice for merchant cash advance lenders to provide a fully digital end-to-end solution, there are downsides to this process as well. From the commercial borrower’s perspective, the fast online process aids him in his quest for a fast business loan. On the other hand, the question remains if digitally signing your name on a Docusign truly benefits you in the long run.
Does Docusign Help Merchant Cash Advance Lenders Hide Prepayment Penalties? It may be inadvertent. Because the merchant cash advance process is 100% online, many questions may remain unanswered because Docusign prompts the user to move from signature block to signature block without actually reading what they’re signing. For example, if you’re only required to sign, then did you or the lender make an effort to understand the rate on the merchant cash advance, the prepayment penalty or even the discount, was there a personal guarantee and what happens in the event that the business has no revenue? All of these questions should be equally important to the business owner, but may be overlooked when there’s a time crunch to acquire fast business funding. Merchant cash advance agreements are structured as a lump-sum payment to a business in exchange for an agreed upon percentage of future revenue. Since these contracts are written as merchant cash advances and not loans, there is no interest rate. Should the merchant’s revenue fluctuate, payments to the lender will also change in-kind. This type of flexibility benefits the merchant in many ways because unlike a conventional loan, the payments will decrease during the merchant’s slow seasons.
Of course, sometimes the opposite is true. Let’s go back to the stone fabricator example once again. Let’s assume that he took a $50,000 merchant cash advance. The agreed upon term to pay back the note is 12 months, but the merchant is confident that he can pay off the note somewhere between three and six months.
So, in effect, there is no prepayment penalty on a merchant cash advance. Instead, merchant cash advance lenders encourage merchants to take a shorter term, assuming the daily or weekly payments don’t negatively impact their cash flow. Again, should a merchant opt to pay off a merchant cash advance before the end of the term, lenders will provide a discount. While that discount may vary, let’s examine a prepayment discount offered by Cardiff.
Cardiff's 2020 Early Payoff Discount
| Amount | Interest | Term | Payback |
| $50,000 | 2% PER MONTH | 12 MONTHS | $62,000 |
| If paid back in 6 months | $56,000 | ||
| If paid back in 3 months | $53,000 |
In this example, the stone fabricator took a $50,000 merchant cash advance from Cardiff. Unlike a traditional loan, the process was fast, completely online and funds were wired to the merchant’s business checking account on the same day. While Cardiff doesn’t assess a prepayment penalty to notes paid back in advance, they do offer deep discounts. As shown above, should the stone fabricator pay back his advance before the end of the term, he’ll save 50%-75% on the interest costs.
For business owners looking for a short-term funding solution that’s fast and provides for an early payoff discount, Cardiff may be the best funding partner for you.
Equipment Leasing Prepayment Penalties
Let’s continue to build off the example of the stone fabricator. In the exercise above, we reviewed how many merchant cash advance lenders don’t assess a prepayment penalty. Instead, we outlined the deep discount that Cardiff provides to merchants who plan to pay off their note in advance.
Similarly, equipment leasing contracts differ from conventional loan agreements in that there isn’t an interest rate and therefore no breakdown between principal and interest exits. Let’s continue with the stone fabricator example to help uncover what prepayment penalties may exist once he decides on an equipment lease.
After taking a merchant cash advance, the stone fabricator may realize that there is a lot more to just buying large slabs of stone from a wholesaler. Unlike buying the stone from a local retailer, he’ll need a bridge saw to cut it down, a polisher to grind down the stone to provide a smooth and lustrous finish and also a router to bevel the edges. While buying the stone from a wholesaler is a practical solution just given the cost disparity between purchasing directly from the quarry in Brazil and buying stone at a local retailer, it also presents some potential downsides. Given that the stone is in its raw form, additional equipment is required to deliver a product to the customer.
Equipment leasing is a practical solution for the stone fabricator needing to purchase relatively expensive assets since it does not require the merchant to purchase the assets upfront. Instead, with equipment leasing, the business owner is able to lease the assets and write off the full payments (which may include property and local/state tax). Going back to the example of the stone fabricator, let’s assume he was able to lease all of his equipment and only make a relatively small monthly payment for a term of 72 months. Given the discount he’s able to secure through buying unfinished slabs of stone directly from a Brazilian quarry, he may be able to pay off his lease ahead of time. But is it a good idea?
Equipment leases don’t break down principal and interest. Instead, equipment lessors use lease rate factors which can be multiplied by the equipment cost to give a monthly payment. Given the equipment described above which could be purchased from PB Marble Services in Sherman Oaks, California, the stone fabricator’s payment would be approximately $6600 a month plus sales tax. That’s a lease rate factor of 0.019.
How to Calculate an Equipment Lease Interest Rate
Monthly Payment/Equipment Cost=Lease Rate Factor (LRF)
To determine a lease rate factor, divide the monthly rental payment by the equipment cost. Your result will be the lease rate factor, which is the lease payment as a percent of the total cost of the leased equipment.
Using the example above, the stone fabricator bought a CNC stone saw for $150,000, a stone polisher for $55,000 and a stone router for $150,000 for a combined cost of $355,000. By leasing the equipment for 72 months, his payment at a lease rate factor (LRF) of .019, his monthly payment excluding sales and property tax is approximately $6600. Given the long-term nature of the finance contract, should the merchant want to pay off the lease ahead of time (e.g. at month 36 or half-way through his term) the equipment financing company might only discount the remaining payments by 4% to 5%. That’s a small savings overall-only about $5,000-$6,000 in total savings.
Why You Should Pay off Your Equipment Lease Early?
Ultimately, paying off an equipment lease early has both benefits and downsides. While there isn’t a prepayment penalty for paying off an equipment lease early, the small savings afforded to the end-user customer may not constitute a true benefit overall either. Most likely, the decision to pay off an equipment lease early is a highly subjective one and may be more of a cash flow decision than anything. If a merchant is worried about long-term debt and is in a cash position to pay off the lease, it may make sense at that moment in time. Additionally, if the merchant is looking to sell his business and is looking to free himself from the encumbrance of the personal guarantee tied to the equipment lease, it may also make sense to pay off the equipment lease in advance.
Keep in mind that unlike conventional loans, equipment leases have a residual on the backend. Should you decide to pay off the equipment lease early, expect to pay a balloon payment that could range from 10%-40% of original equipment cost.
Equipment Finance Agreement Prepayment Penalties
In the earlier example, the stone fabricator was able to secure both a merchant cash advance and an equipment lease. Since the merchant was considering paying off both prior to the end of the term, it was worth investigating how an early payoff discount or prepayment penalty may affect the overall cost of the financing. As depicted, the merchant cash advance discount was considerable. On a 12-month term, the fabricator could easily save up to 75% of the overall interest by paying off the advance in six months. Unfortunately, by choosing an equipment lease, the merchant’s ability to prepay the note is complicated by the fact that there is no amortization. As a result, the value of the principal does not decrease over the life of the note. In general, non-amortizing financing like equipment leases have higher interest rates because they’re usually unsecured. For the stone fabricator, choosing an equipment lease was a decision based purely on the ease to obtain the financing.
In comparison to a conventional bank loan, equipment leases offer fast approvals, require limited documentation and apart from a personal and corporate guarantee and furthermore are generally only secured by the equipment itself; requiring no additional assets as security. Unfortunately, for business owners looking to pay off an equipment lease prior to the end of the term, equipment leases offer no real prepayment discount, though there is also no prepayment penalty. Another impediment to paying off an equipment lease early is the fact that equipment leasing companies generally structure the financing with a balloon payment or residual on the backend of the transaction.
Therefore, while paying off a merchant cash advance prior to the end of the term is generally a good idea, if you have the same intention with an equipment lease, there’s likely to be a better alternative. Read below how an equipment finance loan, also known as a capital lease might be a better option for business owners who are looking for fast access to business financing, a true prepayment discount and also no residual at the end of the term.
Similar to an equipment lease, an equipment finance agreement (EFA), also known as a capital lease or equipment loan offers flexible financing options to business owners needing fast access to equipment financing. There are some major differences between leasing and financing, so it bears examining the advantages and disadvantages prior to committing one or the other.
Differences Between Equipment Leasing and Equipment Financing
| Prepayment Discount | Residual Payment | Dollar Buyout | Depreciation Credit | |
| Equipment Leasing | None, Non-Cancellable | Yes | No | None |
| Equipment Financing | Yes, ~5% | No | Yes | Yes |
As depicted above, equipment leasing holds little advantage over equipment financing for the merchant who intends to keep the equipment at the end of the term and is considering paying off the equipment loan prior to the end of the term. From our research, we found that most equipment financing companies offer a prepayment discount of approximately 5% off the total remaining balance.
What are the IRS True Lease Guidelines
- The lessee does not have the option to purchase the asset at the end of the lease term for less than the Fair Market Value (FMV)
- The expected residual value of the asset being leased is at least 20% of the original purchase price and the lessor bears all the residual risk
- The leased asset must be general-use property and must have at least a 20% remaining useful life at the end of the lease term
- The equipment lease must satisfy the Internal Revenue Service (IRS) requirements for Profit Exclusive Tax Benefits, Cash Flow and Minimum Equity Investment
Keep in mind that we’re comparing an equipment lease versus an equipment finance agreement or equipment loan. A true lease, also known as a tax-lease must pass the accounting requirements for the lessor to claim any or all the tax-related benefits, including but not limited to depreciation.
Line of Credit Prepayment Penalties
A commercial line of credit (LOC) is a preset borrowing limit that can be used at any time. The business can access the capital as needed and it’s repaid, the merchant can again access the open line of credit.
A merchant has access to the line of credit at any time as long as they do not exceed the maximum amount (credit limit) outlined in the agreement and meet any additional requirements such as payment timeliness.
While there are no prepayment penalties on commercial lines of credit, there are disadvantages nonetheless. Continue reading to learn more about the downsides of applying for and using a business line of credit.
What are the Disadvantages to a Business Line of Credit
The three biggest disadvantages to a business line of credit are the time it takes to apply, the difficulty in getting approved and the relatively small credit limits. Read below to learn more about the downsides to apply for a business line of credit.
- Business lines of credit are generally time consuming to apply. Most financial institutions will require the following along with an application signed by 100% of the business ownership:
- Business Bank Statements
- Personal Bank Statements
- Business Tax Returns
- Personal Tax Returns
- Most recent Profit & Loss Statement (P&L)
- Formation documents (Article of Incorporation or Operating Agreement)
- Personal Credit Reports
- Business Credit Report
- Because most banks and financial institutions prefer to make loans collateralized by real estate, they tend to be quite picky with whom they approve commercial lines of credit. Given the laundry list of items required to apply, banks and financial institutions have ample documentation to disqualify applicants that are either considered borderline or may otherwise be ineligible.
- Another disadvantage of a business line of credit is that often times the limit is small relative to a conventional business line. While the credit limit of a business line of credit will usually be larger than a business credit card, the interest rate will likely be higher as well.
As outlined above, while there may not be specific prepayment penalties assessed on commercial lines of credit, there are definitely disadvantages to taking one. Additionally, because lines of credit are revocable, there are numerous triggers that banks and financial institutions alike can lean on to call or demand a line be immediately repaid.
If you’re a business owner considering any type of commercial financing, be sure to check with the bank or financial institution you’re applying with if you’re concerned about any prepayment penalties. Additionally, you may consider reviewing any commercial loan or lease agreements with a CPA and/or a business attorney.
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