Money Matters: When Does It Make Sense to Pay Off a Loan Early?

Paying off a loan early—what could be better? It might sound like that’s definitely the way to go. But as it turns out, there may be a few select moments where it doesn't make sense to finish your payments ahead of schedule.

Let’s find out why not.

The big question to ask yourself

If you’re thinking about paying your loan off early, there’s one big question to ask yourself: “Is the prepayment incentive worth the opportunity cost of not having cash later on?” That sounds a bit complicated, so let’s break it down into two different factors:

1. The Prepayment Incentive. The difference between “prepayment incentive” and “prepayment penalty” is mostly a matter of perspective. What matters, though, is that you’ll usually be able to save some money if you pay off your loan before the end of its term. There are different kinds of prepayment incentives and penalties: you might have a flat percentage rate of the remaining balance to pay, a sliding scale of percentage rates depending on how far along the term you are, or something else.

Regardless, knowing your loan’s prepayment incentive, and understanding how much you could save by prepaying is an important part of figuring out whether to pay it off early.

2. Capital Needs. You took out a loan because you needed more capital to run and grow your business. If you’re considering paying off your loan early, then you’ve probably fixed up whatever you had to—and you’ve got the cash necessary to clear your debt on-hand. But might paying off early—and losing a lot of that capital all at once—hurt your cash flow now? You could potentially lose the money buffer you’ve built up for emergencies or last-minute opportunities.

Also, it’s much easier to spend cash you have, instead of taking out another loan next time you need extra capital. There’s a possible opportunity cost to fully paying off your loan early—you won’t have access to that fluid funding anymore, since you’ll have spent so much in bulk to prepay. It might be the case that paying weekly or monthly interest could be worth having a fuller bank account.

So back to the big question: “Is the prepayment incentive worth the opportunity cost of not having cash later on?” Hopefully this is a bit clearer now. Does the value of the money you save by prepaying outweigh the dangers you tempt by having less capital down the line? That’s the core question to figuring out whether or not it makes sense to pay your loan off early.

Prepaying for different kinds of loans

Let’s think through how to figure out whether paying off a loan early makes sense for two common kinds of loans:

1. Short-Term Loans. Short-term loans last from three to 18 months, so there tend to be pretty limited prepayment incentives. You might get offered discounts to pay back early, but the dollar value of these savings are rarely as important as how your cash flow might get affected.

Your decision to pay a short-term loan off early or not is dependent on whether you’ve solved a one-time cash flow problem with that loan, or if, instead, your cash flow could be hurting again when you prepay. Plus, many short-term loans come with a "payment schedule" and not an "amortization schedule," so you're not sure what's going towards principal and what's going towards interest. Many short-term lenders might offer a flat discount on the remaining balance, or no prepayment incentive at all.

The point is, you might not save a lot on interest if you prepay a short-term loan. If you're unsure, definitely reach out to your accountant for help.

2. Traditional Term Loans. If you’re constantly taking out term loans for different opportunities and paying them off early, you might want to consider a line of credit instead.

But if you’re not yet eligible or just prefer term loans, then keep in mind that you don’t need to pay a loan off early—even if you’ve accomplished everything you set out to do with the money you borrowed. Instead of rotating between loans, you could sit on the money and dip into it again when you need it.

There are transactional costs to finding a new loan every time you’re looking for funding; after all, it takes time, effort, and sometimes more money, since you can’t predict what you’ll wind up with exactly.

If you don't foresee yourself needing capital in the future, then prepayment is a good option here. Most longer-term lenders will provide you with a true amortization schedule, meaning you'll know exactly how much you're paying towards interest and principal. Many longer-term loans don't have prepayment penalties either, so you potentially will save money in the long run if you decide to prepay.

Remember to do the math and consider the opportunity costs of paying a small business loan off early—it’s not always as cut-and-dried as you might think.