Curtailments on loans are when a borrower makes additional payments outside of the regular payment schedule to reduce the amount of time or money they owe, and to potentially save money on interest fees. Curtailments exist on personal loans, mortgages, and business loans and all three types of loans may have prepayment penalties if you agree to them.
Business loans (both small business loans and commercial) tend to have higher interest rates than a personal loan or mortgage, so it is more appealing to make curtailment payments on these. Doing so can speed up the repayment process and decrease the amount of interest you pay.
Why Borrowers Make Curtailment Prepayments
The reason a borrower will make curtailment payments is to save on interest payments, to clear a debt so their business credit score can increase, or because they have extra cash flow that will not be needed soon, and they want to have less debt outstanding. The most common reason is likely to save money on interest.
If you have a current fixed rate loan for $100,000 and a 5% interest rate, and you make monthly payments, your interest payment is $416.66.
(principal*interest rate)/12 = monthly interest payment
($100,000*.05)/12 = $416.66
If you prepaid $5,000 as a curtailment before this monthly payment, you could pay interest on $95,000 instead of $100,000, reducing your new monthly interest fee to $395.83.
($95,000*.05)/12 = $395.83
The $20.83 you save may not seem like much right now, but over the course of 10 years, or at a higher interest rate, it adds up.
Pro-tip: Check with your state to see if prepayment penalties are allowed or not. Some states have restrictions on the lender based on the amount of the loan, the interest rate being charged, or the usage of the loan.
Because lenders make their money from interest payments, it is not in their best interest to allow curtailments without a way to recover funds. This is where prepayment penalties come in.
Curtailment Penalties
There are multiple types of curtailment (prepayment) penalties that may be present on a loan. Being familiar with them will make it easier to find them in your loan agreement and give you the ability to negotiate them down or away before you sign.
The types of loan curtailment penalties include:
- Balloon payments which are large lump sums paid to the lender and normally at the end of a loan’s term. These are more common with short-term loans.
- Declining percentage, also known as a step-down, is a type of prepayment penalty where the amount you are charged for the curtailment decreases over time. This is popular with lenders because it discourages early principal reductions.
- Defeasance is not a prepayment penalty, but it is where you replace the collateral on a loan with another asset like a bond equal to the remainder of the loan. The new assets clear the debt and help you to avoid a prepayment penalty, but you are now leveraging those assets.
- Fixed prepayment is a fixed amount of money you owe when you make a curtailment and finish paying the loan off early. Unlike a declining percentage or step-down loan, the penalty amount is fixed, regardless of whether you pay the balance in one year or 10 years.
- Time based is when a fee is applied when you’re paying off the principal of the loan faster than expected.
- Yield maintenance penalties are most common in commercial real estate where the borrower pays the debt before the maturity date and pays a fee to compensate the lender for the loss in revenue.
Pro-tip: Look for lockout periods which are set amounts of time where you are not allowed to make prepayments. By negotiating this out of the loan contract, you can reduce the principal amount owed faster and reduce interest payments, saving you more money now vs. having to wait for a lockout period to end.
How to Negotiate Prepayment Penalties Out
Each lender will be different, just like your situation will not be the same as a borrower whose business is in a different niche. That means you’ll need to adjust your negotiations to the type of loan you are applying for and to your specific situation.
There are starting points you can use when negotiating a prepayment penalty out of a business loan contract, regardless of industry or loan type. The goal is to reduce your risk as a borrower so that the lender wants your business over that of other applicants. Here are a few options you can try.
- Agreeing to a large deposit gives the lender more of a safety net if you default, making you a good prospect to lend money too. If you agree to the larger deposit, you may be able to negotiate the other terms like no prepayment penalties.
- Offer additional collateral, bonds, or real estate that gains value to reduce the lender’s risk in the event of a default. This extra safety net gives you some leeway to remove penalties and lockout periods.
- If you have a nest egg and a high personal credit score, offer a personal guarantee as a way to get leverage and remove the prepayment penalty.
- When your company is on a growth trajectory and your business plan will require additional business loans or financial products like a business line of credit or business credit card, see if you can commit to using the same lender. The repeat business will mean more revenue for them in the future, giving you some leeway to negotiate the prepayment penalty out of the new contract.
Curtailments mean prepayments on a loan. These can help you as a borrower to save money or reduce your debts. If you don’t read your loan contract closely, you may have to pay a penalty when you make them. This is why you’ll want to negotiate them out or down before you sign a loan agreement.
