Curtailments in a business loan are prepayments a borrower makes to a lender to:
- Lower their interest payments and save money
- Decrease the amount of time they have the loan so they can raise their business credit score faster
- Free up cash flow for the future sooner
- Decrease the total debts owed so they can be more creditworthy if they’re applying for a second business loan.
Curtailments are appealing to borrowers because of the benefits above, but these same benefits lower the profit for the lender which is why lenders apply curtailment penalties.
Curtailment penalties or fees can be called:
- Balloon
- Defeasance
- Fixed prepayment
- Step down or declining percentage
- Time-based
- Yield maintenance
This guide walks you through the types of curtailments you can make as a borrower and how to negotiate your loan agreement before you sign. By knowing what to look for, you may be able to get prepayment penalties removed or lighten the prepayment fees that the lender applies to your business loan.
The Types of Curtailment Penalties
Each curtailment will have a different type of penalty depending on the amount of the prepayment or the timeframe if you don’t negotiate them out before you sign the loan agreement. This applies to both large and small business loans. If you’ve already signed your loan agreement and didn’t look for them, don’t worry, curtailment penalties are common, and you can work with them.
Here’s the most common types of curtailments or prepayment penalties so you can find them in your loan agreement and find an option that works for you to save more money or reduce the amount of penalty when they’re unavoidable.
Balloon Payments
Balloon payments are a type of curtailment where the borrower pays a large sum of money instead of a smaller payment at any duration of the loan, but most commonly at the end. Although balloon payments are more common on short-term business loans rather than long term, they can be done with both.
If a balloon payment is made at the beginning of the loan, it can lower the interest payments if the interest is based on the principal (amount owed). They are common at the end of short-term business loans to clear the debt off of the borrower’s business credit report and free up cash that would have gone to making monthly loan payments.
Short-term loans cover immediate needs to boost profit or cover expenses while waiting for accounts receivable. Because borrowers want to clear debt and will have cash as the loan comes to term, balloon payments are more common here.
Defeasance Payment
Although a defeasance payment isn’t a curtailment as you’re substituting assets like government-backed treasury bonds to clear the current items you set as collateral, it does clear the debt, as the borrower has paid off the loan. Instead of using cash flow to cover the cost, the non-cash assets keep the business with liquid assets and allow the debt to clear.
Borrowers may use defeasance payments to increase their cash flow, gain the ability to sell equipment that was listed as collateral so they can upgrade operations, or because they want to clear the debt from their business credit report and raise their score.
Fixed Prepayments
Lenders charge a fixed prepayment penalty when the borrower pays off the loan, and the penalty is a set amount regardless of how quickly the loan is paid off or the size of the curtailment payment.
This penalty can be negotiated before the borrower signs their loan agreement, so if the borrower knows they’ll be paying the loan more quickly, they’ll want to negotiate a lower fee or have the penalty clause removed completely.
Step Down or Declining Percentages
Step down and declining percentage penalties are better for the borrower and the lender as the amount of the penalty, usually a percentage, decreases over the time of the loan. If the borrower knows they’ll be more profitable in a few years because of the investments they’re making now, the penalty is reduced, lowering the fee the borrower pays and saving them more money.
The lender benefits from step down and declining percentage penalties because they make their money on the interest payments, and by having larger penalties in the beginning of the loan, the borrower is less likely to make curtailments, so the lender stays more profitable longer. The lender either gets the expected interest payment or the lower interest payment with a fee on top, which keeps the lender’s profits high.
Time-Based
Time-based curtailments are a penalty for paying off the business loan before the agreed-upon date. These are more common in SBA loans like the 7(a) and 504, which you can find information on here, but any type of business loan can have them.
Although you cannot negotiate the prepayment penalty on government-backed loans from the SBA, you can negotiate them out when you go with a traditional bank or an alternative lender.
Yield Maintenance
This type of prepayment penalty is where the lender collects the full amount of revenue they would have “yielded” on interest payments instead of losing the interest if the borrower pays their loan off early.
The Benefits of Making Curtailment Payments
As a borrower, you can benefit by making curtailment payments on a loan by:
- Reducing the amount of interest you pay over the term of the loan.
- Getting the debt removed from your credit report so you can increase your score more quickly.
- Improving your creditworthiness in case you need a new business loan, as there will be less debt outstanding.
- Freeing up collateral you want to sell or upgrade, as it’ll be removed from the UCC lien when you either substitute it out or clear the loan.
Ways to Negotiate Curtailment Penalties Out or Down
Not all lenders will be willing to remove all curtailment penalties, but many will be open to negotiating the terms of prepayment penalties if you have a good credit score and are a borrower with multiple lender options. Some of the ways you may be able to get a lender to be flexible are:
- Switching the type of business loan from an SBA business loan to a niche business loan like equipment financing or a working capital loan. Because the SBA loan requirements do not apply to non-SBA backed loans, the lender can have more flexibility on the terms.
- Offering a larger deposit on the loan to offset risk, providing the lender with a cushion. Because you are a lower-risk borrower, the lender may want your business even more and become flexible with curtailment penalty fees and clauses.
- Sharing future business plans that show you’ll be taking more business loans. When there is an opportunity for a longer-term relationship and the lender feels confident that you’ll be able to make payments, they may waive curtailment fees so that you take your next two or three business loans with them.
Curtailments benefit the borrower on a loan because they save the borrower money, which is why lenders charge a penalty depending on the type of prepayment the borrower makes. By knowing the types of curtailments and penalties, borrowers can make better decisions for their financial needs and save money while clearing their debts faster.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
