Early loan repayment

What it means

Early loan repayment means the borrower repays a loan or part of it sooner than the repayment schedule provides. It may be an extra payment that reduces the principal or full repayment of the entire balance. The result is a saving on interest for the period the debt would otherwise have run.

For business loans the conditions of early repayment are set by the contract. The bank usually charges a fee to compensate for lost interest and refinancing costs, especially with a fixed rate. For consumer loans and mortgages the law caps the fee, and in some cases, such as at the end of a fixed-rate period, early repayment is free.

With a floating rate the fee is usually lower or nil, since the bank does not bear interest rate risk. With a fixed rate it can be substantial, especially if market rates have fallen in the meantime. Before deciding, you need to know what kind of rate the loan has and exactly what the contract says.

How it works in practice

Companies repay loans early when they have surplus cash, when they want to cut leverage before a sale or new financing, or when refinancing with a cheaper loan. The decision should be calculated: compare the interest saved with the fee and with the return the cash would earn if it stayed in the business.

With an extra payment you choose whether to lower the instalments or shorten the term. Lower instalments ease cash flow; a shorter term saves more interest. Some contracts allow a free extra payment up to a certain amount each year, which is worth using.

Early repayment can also be linked to covenants. If the loan agreement's conditions are breached, the bank may instead demand immediate repayment of the whole loan. When planning financing, watch both directions: when the company wants to repay and when it might be forced to.

What to watch out for

Beware of hidden costs. Besides the early repayment fee, the bank may charge for releasing collateral, deleting a charge or amending the contract. Refinancing adds the new bank's fees. The overall saving should be calculated only after including all of these items.

In the accounts, early repayment also means writing off any arrangement fees that were being deferred, and expensing the early repayment fee in the period. A deferral forgotten after the loan is repaid is a common error that only an audit uncovers.