A prepayment penalty is what the lender charges to be repaid before it expected. Most business debt uses one of a handful of structures: a step-down percentage that falls each year, a flat percentage, yield maintenance, defeasance, call protection on private credit, SBA's prepayment fee on 7(a) loans of 15 years or more, or, for cash advances, a payoff of the full remaining purchased amount unless the contract grants a discount. Find the prepayment section of the note, identify the structure and the trigger, then add the premium to principal, accrued interest and fees to get the payoff before deciding whether a refinance is worth it.
- Step-down
- A percentage of the prepaid amount that falls each year, such as 5-4-3-2-1
- Yield maintenance
- Pays the lender the interest it loses when rates have fallen
- Defeasance
- Replaces the loan's collateral with government securities; mostly real estate loans
- SBA 7(a)
- 5%, 3% and 1% of the prepaid amount in years one to three, on loans of 15 years or more
- Cash advances
- The full remaining purchased amount, unless the contract grants an early-payoff discount
- Also check
- Interest rate swap breakage, which sits outside the note
The structures, side by side
Every structure answers the same question for the lender: if this loan is repaid early, how much of the income I priced it on do I keep? They answer it very differently, and the difference can matter more than the interest rate when a refinance or a sale is likely.
| Structure | How the charge is set | Where you see it | What moves the cost |
|---|---|---|---|
| Step-down | A set percentage of the amount prepaid, falling each year until it reaches zero; a 5-4-3-2-1 schedule means five points in year one, four in year two and so on | Bank term loans, equipment loans, commercial mortgages | Only the date you prepay |
| Flat percentage | One percentage of the amount prepaid, whenever it happens | Some bank and non-bank term loans | Nothing but the balance |
| Yield maintenance | The present value of the interest the lender loses, measured against the current yield on government securities of similar remaining term | Fixed-rate commercial real estate and some fixed-rate term loans | Market rates: expensive when rates have fallen, often only a minimum when they have risen |
| Defeasance | The borrower buys government securities that produce every remaining payment, and they replace the collateral; the loan is not repaid, it is substituted | Securitized commercial real estate loans | Market rates, plus third-party costs |
| SBA 7(a) prepayment fee | 5% of the prepaid amount in year one, 3% in year two and 1% in year three, when more than 25% is prepaid in that year | 7(a) loans with a maturity of 15 years or more | The year and the size of the prepayment |
| Call protection | A premium or make-whole payment during a non-call or soft-call period | Private credit and unitranche loans | The date, and sometimes the reason for repayment |
| Cash advance payoff | The full remaining purchased amount, less any early-payoff discount the contract grants | Merchant cash advances | Whether a discount exists and has been put in writing |
For how these compare when you are choosing a new loan rather than leaving an old one, see yield maintenance vs step-down prepayment and prepayment penalties and call protection by lender type.
How to read the prepayment section of your note
The clause is usually headed Prepayment, Voluntary Prepayments, Prepayment Premium or Make-Whole, and on a larger facility it may sit in the credit agreement rather than the note. Six questions turn it into a number:
- Which structure? Look for a year-by-year table (step-down), a single percentage (flat), a formula referring to Treasury yields or a discount rate (yield maintenance), or a reference to substitute collateral (defeasance).
- What is it measured on? Most charges apply to the amount prepaid. Some apply to the whole outstanding balance, which makes even a partial paydown expensive.
- What triggers it? Voluntary prepayment almost always does. Refinancing, a sale of the business, and a casualty or condemnation event are sometimes treated differently. Mandatory prepayments, such as an excess cash flow sweep or asset-sale proceeds, are often exempt.
- Is there a free window? Some notes allow a partial prepayment each year without charge, or open fully in the last months before maturity.
- Is there a lockout? Some loans cannot be prepaid at all for an initial period, whatever you are willing to pay.
- What notice is required? Most notes require written notice of prepayment in advance. Miss it and the closing date can move.
Read the definitions as well as the clause. A step-down that looks gentle can apply to the full balance, and a make-whole that looks severe can end within months.
The structures in more detail
Step-down and flat charges are the easiest to price, because they depend only on the date. On a 5-4-3-2-1 schedule, prepaying a balance of 800 in year two costs 32: four for every hundred prepaid. The same prepayment in year five costs 8, and in year six nothing. Where a refinance is optional, waiting for the next step-down date can be worth real money.
Yield maintenance is designed so the lender ends up as if the loan had run to maturity. If your fixed rate is three points above what government securities of similar remaining term now pay, and 600 of principal has four years left, the lender loses roughly 18 a year; the charge is that stream discounted back to today, somewhat less than 72, since later years count for less. The same loan on a step-down schedule in its second year would cost 24. When rates have risen since the loan closed, the formula can produce little or nothing, and many notes then apply a stated minimum. The Treasury yield used, the discount rate and the minimum are all in the definition.
Defeasance is not a payment to the lender at all. The borrower buys a portfolio of government securities whose payments match the loan's remaining payments, and those securities replace the property as collateral. The cost is the price of that portfolio above the loan balance, which rises as market yields fall, plus the fees of the consultants, accountants and successor borrower involved. It is found almost only on securitized real estate loans, and it takes coordinated work to execute.
SBA's prepayment fee applies only to 7(a) loans with a maturity of 15 years or more, typically those financing real estate, and only when more than 25% of the balance is prepaid in one of the first three years. Refinancing a balance of 2,000 in full during year two costs 60. Paying down one-fifth of it in year one costs nothing, because it stays under the threshold. After year three there is no SBA fee. Loans shorter than 15 years carry none. The CDC portion of an SBA 504 loan is different: its debenture carries its own prepayment premium, which declines over the first half of its term. See the SBA prepayment penalty and refinancing an SBA loan.
Cash advance payoffs work differently because an advance is a purchase of future receipts, not a loan. The funder bought a fixed amount; paying early usually means paying the whole remaining amount, with none of the interest saving that paying off a loan early brings. If an advance of 100 was sold for 140 and 60 has been remitted, the payoff is 80 unless the contract grants an early-payoff discount. Where a discount exists, get it into the payoff letter before relying on it. See the real APR of a cash advance and refinancing advances into term debt.
The charge that is not in the note: swap breakage
Many floating-rate bank loans are paired with an interest rate swap that fixes the borrower's rate. The swap is a separate contract. Repaying the loan does not end it; terminating it does, and termination settles its market value. If rates have fallen since the swap was signed, the borrower owes the bank that value. If rates have risen, the bank may owe the borrower. Either way the number is not in the note, it changes daily, and the bank's payoff letter may not include it unless you ask. Ask.
Working out the actual payoff
A refinance decision needs the real cost of leaving, not the balance on the last statement. Build it line by line, then confirm it against the lender's written payoff letter.
| Line | Where it comes from | Example |
|---|---|---|
| Principal outstanding | The latest statement, adjusted for payments before closing | 800 |
| Accrued interest to the payoff date | The daily interest figure times the days since the last payment | 6 |
| Prepayment premium | The note's prepayment clause, applied to the amount prepaid | 32 |
| Swap termination | The bank's swap desk, if a swap exists | 0 in this example |
| Payoff, release and legal fees | The note and the lender's payoff letter | 2 |
| Total cost to exit | 840 |
That 40 above the principal is the amount the refinance has to recover, on top of the new loan's own fees, before it saves anything. The method for testing that is on the refinance break-even, and the way to compare the new offers on a like-for-like basis is on interest rate vs all-in cost.
Then read the new loan's prepayment clause with the same care. A refinance into a loan with heavy call protection trades one exit cost for another. Transparent's financing model carries the exit cost of the existing debt and the new debt through each option, so the comparison lenders and owners see is on the same basis; see the lender package.
Common questions
- Can a prepayment penalty be negotiated away?
- Sometimes. A lender being repaid because the business is being sold, or one that wants the loan off its books, may reduce or waive it. A lender that will lose a performing loan to a competitor rarely does. Ask in writing, and get any waiver into the payoff letter.
- Does paying off an SBA loan early always cost a fee?
- No. SBA's fee applies only to 7(a) loans with a maturity of 15 years or more, only in the first three years, and only when more than 25% of the balance is prepaid in a year. Most working capital, equipment and acquisition loans have shorter maturities and no SBA fee.
- Is a prepayment penalty charged when the business is sold?
- Usually, since a sale almost always repays the loan. Some notes treat a sale differently from a refinance, so check the trigger language. The penalty is paid at closing out of the sale proceeds, so it comes off what the seller takes home.
- Why is yield maintenance so expensive right now on my loan?
- Because it measures your rate against current government yields. If yields have fallen since your loan closed, the gap is wide and the charge is large. If yields rise before you prepay, the charge shrinks.
- Does paying off a merchant cash advance early save money?
- Only if the contract grants an early-payoff discount. Otherwise the payoff is the full remaining purchased amount, whenever it is paid.