Prepayment premium: Overview, definition, and example
What is a prepayment premium?
A prepayment premium is a fee that a borrower must pay if they repay a loan earlier than agreed. Lenders charge this fee to compensate for lost interest they would have earned over the full loan term. It ensures that the lender receives a certain return on the loan, even if the borrower pays it off early.
For example, if a business takes out a five-year loan but repays it in three years, the lender might charge a prepayment premium as a percentage of the remaining loan balance. This discourages early repayment unless the borrower is willing to cover the additional cost.
Why is a prepayment premium important?
Prepayment premiums protect lenders from losing expected interest payments and help them manage financial planning. For borrowers, understanding this fee is crucial because it can impact financial decisions.
Some businesses might want to repay a loan early to save on interest, but a prepayment premium could offset those savings. Before signing a loan agreement, it's important to check for prepayment penalties and calculate whether early repayment is still beneficial.
Understanding a prepayment premium through an example
Imagine a small business takes out a $500,000 loan with a 5-year term. After three years, the business wants to pay off the remaining balance to avoid further interest charges. However, the loan agreement includes a prepayment premium of 2% on the outstanding balance.
Since the business still owes $200,000, the prepayment premium would be $4,000 (2% of $200,000). The business must decide whether the interest savings from early repayment outweigh the cost of the prepayment premium.
In another example, a real estate developer secures a loan to finance a project but sells the property earlier than expected. Because the lender planned on earning interest for the full term, the developer must pay a prepayment premium to compensate for the lost interest.
An example of a prepayment premium clause
Here’s how a prepayment premium clause might appear in a contract:
“If the Borrower elects to prepay any portion of the outstanding principal before the scheduled maturity date, the Borrower shall pay a prepayment premium equal to [X]% of the amount prepaid.”
Conclusion
A prepayment premium is a fee charged when a loan is repaid early, protecting lenders from lost interest. While early repayment can be beneficial, businesses should carefully consider whether the cost of the prepayment premium outweighs the potential savings.
Understanding and negotiating prepayment terms in a loan agreement can help businesses avoid unexpected costs and make informed financial decisions.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.