As part of Dealstruck’s commitment to transparency, we try to pull back the curtain on the “tricks of the trade” to arm you with the accurate and complete information you need to make the best financing decision.

One common refrain we run across is from merchant cash advance (MCA) providers touting that their product has “no pre-payment penalty.”  What does that mean?

Pre-payment Penalty – n. A prepayment penalty is a fee, usually calculated as a percentage of the outstanding principal balance, charged by some lenders if a loan is paid before its maturity date. These penalties can exist for a variety of reasons – some more legitimate than others – but they often have to do with compensating the originator or investor for costs incurred with entering into the transaction that will not be recovered over the life of the transaction due to prepayment.

For example, a lender that makes a $50,000 interest only loan for two years at 10% would expect to earn total interest of $10,000 over the transaction life.  However, if the borrower pays the loan off after one year, the investor would only earn $5,000.  If there were significant costs associated with providing the financing – marketing, underwriting, compliance – the lender that expected to cover its costs with $10,000 of income now may actually incur a loss.

A prepayment penalty would help cover these costs.  At Dealstruck, for example, we typically assess a 1% fee for every year a loan is paid early.  In the above example, the borrower paying off the loan after one year would be required to pay an additional $500 to exit the transaction early.  In total, the interest cost would be $5,500 as compared to $10,000 if the loan was not paid early.  While it may seem counterintuitive to pay a fee for paying quicker than expected, without such fees it can be hard for lenders to cover costs and continue to offer products with great pricing and service.

MCA providers know that many traditional lenders charge small pre-payment fees, and  they will use this fee, or the lack thereof, as a selling point to lure businesses into what usually is an exorbitantly expensive product.  However, just because you don’t pay a separate “pre-payment fee” for paying down early, there is still a penalty.

As we’ve covered in prior blogs, an MCA is usually priced on a buy-rate: a 1.2 buy rate on $50,000 means that you will pay the MCA $60,000 on either a fixed daily debit or variable daily payment tied to credit card receivables.

Regardless of when the MCA is paid, you cannot exit the transaction without paying the full $60,000.

The two transactions I just described are identical in terms of loan amount and interest cost if paid as scheduled.  However, with a term loan, you can exit the transaction early if you no longer need the capital and incur a $500 fee.  After one year, you would have paid $5,000 in interest and $500 in prepayment fees for a total cost of $5,500.

With the MCA, if you wanted to pay the transaction off early, you would need to pay the entire $60,000. So, even though there is no prepayment fee, it actually costs you $4,500 more to prepay. I bet you never thought that incurring a fee could actually save you money relative to not incurring one.

But wait, there’s more!

Term loans at Dealstruck all amortize, which means that monthly payments include both principal and interest.  In the example above, after one year, there will be only $26,243 of principal outstanding on your loan.  So, prepayment only costs you $262 as opposed to $500.  And, because you only pay interest on the outstanding principal balance each month – not the original loan amount – you actually would only incur $3,931 in interest expense in year 1; not $5,000.  The true cost of exiting a two year loan one year early then would be $3,931 in interest + $262 in prepayment fee for a total of $4,193 (not $5,500).

With an MCA, even though you are paying down the loan on adaily basis, if you try to prepay after one year, you still pay the whole $60,000.  Total interest cost is therefore $10,000 regardless of when you prepay, making it almost $6,000 more expensive to prepay a product with no prepayment penalty than one with a penalty.

As the old economic maxim goes, “There is no free lunch.”  When a lender is telling you there are no fees, that doesn’t always mean they are saving you money.