Overview
Business owners typically seek business loans from time to time for various business purposes, however, sometimes they might want to prepay their debts early. Having business loans may not only burden your business earnings but sometimes also create stress for repayments especially when your business is going through financial strain. As a business owner, you would wish to relieve your debt obligations as soon as you can. However, this entire process may be tedious as it may have penalties involved and lengthy documentation to be completed and submitted to the concerned authorities.
Lenders extend short-term and long-term credit facilities with a certain rate of interest for a predetermined period. However, prepaying your business loan before the end of its tenure might harm the profits of the lender by disrupting its income flows. Thus, in order to compensate themselves against such loss, lending institutions like banks and finance impose a certain fee percentage as loan foreclosure fees.
What is a Loan Foreclosure and how does it work?
Loan foreclosure means prepayment of the principal amount before the end of the actual loan tenure which relieves the interest repayments on the remaining tenure for the borrower but impacts the profitability of the lender institution. Therefore, lenders such as banks and financial institutions levy a certain percentage of the total loan payoff amount as a prepayment fee.
Various kinds of business loans could be settled through prepayment of loans, short-term or long-term debt obligations. To pre-close a loan, the borrower needs to make a formal request to the concerned lending institution for loan foreclosure. On receipt of the request, the lender will see whether the lock-in period (during which the loan cannot be foreclosed) has been completed (where applicable), and then will assess the foreclosure fee/charges, the remaining principal amount, remaining loan period and interest applicable, etc. After which, the borrower can repay the remaining principal with a loan prepayment fee (also referred to as a prepayment penalty), and get the loan account closed.
Loan foreclosure, especially in the case of business loans, could help the corporations to save substantial amounts of money even after the repayment of the prepayment fee in its early tenure. Some lenders, particularly those that keep a certain lock-in period, prevent early prepayment of business loans.
How are Loan Foreclosure Charges calculated?
Loan foreclosure Charges may vary from lender to lender going anywhere between 1 to 4 percent of the outstanding principal amount with the principal amount paid in EMIs. Loan foreclosure charges could be higher for the prepayment of the complete loan liability as compared to the fulfillment of partial loan foreclosure. It should be noted that certain lenders may relinquish foreclosure fees in cases where the prepayment does not surpass 25% of the outstanding balance.
Types of Loan Foreclosure
Partial Loan Foreclosure –
If business entities do not have adequate funds to prepay the entire principal amount to fulfil debt obligation, they could consider pre-paying their loans partially. It aids the debtor to minimize the principal amount apart from lower interest payments. For example, where the business entity NET has taken a business loan of Rs. 50L at the rate of interest of 20% per annum for five years, part-prepayment of Rs. 25L will diminish the liability as well as the interest payments.
Full Loan Foreclosure –
Where the business entity makes the full pre-payment of the principal amount leading to considerable savings in interest payments leading to the cancellation of debt liability altogether, it is known as Full Loan foreclosure. For example, where company YEX had borrowed a sum of Rs. 50L from a bank at an interest rate of 15% per annum for a period of 5 years. Prepayment of the whole principal amount would absolve them of their debt obligation and any interest payments that they would have to pay otherwise for the entire tenure of five years.
Pros of Loan Foreclosure
- Reduces interest costs – When a corporation wishes to obtain loans, they have to make timely interest repayments which are spread over a period and eventually burden the finances of a business particularly in the case of long-term loans or those with higher rates of interest helping business to save costs on interest payments.
- Greater financial freedom – Businesses that have availed multiple loans or credit facilities may lose their financial freedom by being tied to periodical interest payments. Pre-payment of loans allows more financial resources which could be applied for investment purposes or to achieve greater financial liberation. Further, it also helps to improve the Debt-to-Income (DTI) ratio, which is a key factor to be considered while assessing the credibility of the borrower entity.
- Enhanced Credit Score – A loan foreclosure before the end of its tenure helps businesses improve their credit score. Having a higher credit score helps a business to get credit facilities with favorable terms which opens the doors for business growth opportunities.
- Reduce Your Debt Burden – In cases where the borrower’s business entity is unable to make full loan foreclosures, they could consider making partial prepayment of loans. It helps them to minimize the overall burden of debt and reduce interest payments. Making partial prepayment of business loans could also help the borrower entity manage its finances better.
- Fosters Trust and Confidence between borrower and lender – Early foreclosure of loans improves the credibility of a business and fosters trust to secure funds easily.
Cons of Loans Foreclosure
Loan Foreclosure means payment of Fees/penalties.
As discussed before, while loan foreclosure benefits the borrower, it implies loss of interest income for the lender institutions. Therefore, they charge a certain percentage of the outstanding principal sum as a foreclosure fee/prepayment penalty or early payoff penalty, which could discourage the borrower from prepaying their loans. In order to avoid stress related to such fees or charges, business owners should make themselves aware of the applicable charges at the time of agreeing to the terms of the loan agreement.
Charges related to Early termination fees
Sometimes lenders may charge additional fees/charges as a penalty for loan foreclosure from the business entities who wish to fulfill their debt obligations before time. Where the borrower entity tries to cancel the loan, they could have to pay an early loan termination fee, also known as a breakup fee. However, it is not necessary that every lender penalizes the borrower for cancelling the loan before its due date, and thus business owners should pursue loans from lenders who do not charge any such illogical amounts.
Effect on Credit Score
Early prepayment of loans may not always have a positive impact on the credit score of the borrower organization. Prepayment of business loans is unlike foreclosure of personal loans, and sometimes despite timely and regular payments would not lead to any improvement in the credit score.
Setting aside funds for loan foreclosures may not be so easy.
Managing business finances is no easy feat. Small-scale businesses undergoing their growth stage may find it challenging to set aside funds for loan foreclosure by compromising funds for any other purpose which may create unnecessary stress for business owners. Channeling funds to loan foreclosures might also leave the business unprepared for any sudden funding requirements. Thus, business owners have to wait for payouts in the form of business revenues or investment opportunities to be able to gather resources for payment which could take years.
Documentation Required for Loan Foreclosure
- Loan Agreement providing for all terms and conditions;
- Corporate Identification Number (where the borrower entity is a company) and business registration number for other business entities;
- Proof of Registered Address for the business entity;
- Documents showing regular payment of interest amount;
- Previous bank statements clearly state the total principal amount and interest payments.
- Documents showing approval by the lender for prepayment of the loan.
Circumstances under which Loan Foreclosure is favorable
Although charges like loan foreclosure fees or termination charges may discourage borrowers from prepayment of loans, however, they should strongly consider loan prepayment in the following circumstances-
- High interest rates the interest rate applicable on the loan is way too high, the savings made on loan foreclosure would be a smart idea against the long-term interest payments.
- Better Cash Flow – If the business entity has adequate financial resources to manage its operations, then early prepayment of loans could free up more financial resources offering better flexibility and better cash flow.
Final Thoughts
Therefore, as a business owner, whenever you look for business loans, it is necessary to consider the terms and conditions applicable, assess and compare options, and finally consider the charges applicable for loan foreclosure in order to reach a wise decision. While loan prepayment may lead to savings in interest payments, channeling a substantial amount towards debt cancellation could impact the financial well-being of your business.
Business entities should consider lenders specifically known for charging low fees/charges for prepayment of loans or no extra charges for debt cancellation. Further, the terms and conditions of the loan agreement should be carefully assessed, including any lock-in period on the loan foreclosure. It is a good idea to carefully assess the prepayment charges in advance and then make a decision based on the long-term goals of your business, or seek expert guidance throughout your banking journey.
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