When you’ve taken out a short-term loan, you may consider paying it back before the term is up. This might not necessarily be in your best interest. Here’s a closer look at why you should or should not pay back your short-term loan early.
Why Pay Back a Short-Term Loan Early?
Business owners frequently look to pay off short-term loans early when they are looking to take out a loan for more money. In this situation, your new lenders for your new loan would look to buy the left over amount of your old loan, plus add in the new amount of money you need and roll it into one loan. This is the most common reason people choose to pay back short-term loans early.
Where This Can Go Wrong
The second lender will take a portion of the loan you take and use it to pay off the remained of the first loan you had. Where this can go wrong is when the first lender has no interest forgiveness, meaning you still have to pay the interest on your first loan even though you’ve paid it off. Now, you will be paying interest on your second loan which is covering your first loan plus the initial interest, so you are essentially be charged double interest for that left over money on your initial loan. Additionally, some loans have prepayment penalties which would be a percentage of the left over loan, if you were to choose to pay off your loan early. This can get pretty expensive as well.
Understand Your Business
Most business owners do not really understand their margins, and for this reason, taking out short-term loans and paying them off early with new loans can be a dangerous cycle. Typically, business owners over estimate their growth and underestimate their expenses, so they don’t have an accurate idea of what amount of expenses they can take on. Instead, we recommend trying to overestimate your possible expenses and underestimate your growth, that way you can make decisions based on the worst case scenario in case something goes wrong.
Understand Your Current Loan
Knowing how your current loan is structured is vital in determining if you should pay it off early or not. Here at Harbour, almost of our loans have no prepayment penalty after 1 year of payments, however not every loan type out there has the same feature. You should also seek to understand how the interest is loaded into your loan to see if you pay off the loan early, if you will be paying the interest that is left on the loan or not.
When Is Paying Off a Short-Term Loan a Good Idea?
The best scenario when paying off a short-term loan early would be beneficial is when your business is growing and you have enough money to pay it off early, while also not needing a new loan. If you recently signed contracts for a big job, and you know you’re going to have some extra cash lying around, it might be smart to start asking about the terms of your short-term loan to decide if its smart to pay if off early (after considering any fees that may be associated). This way, you will have paid back your obligations while you’re in a healthy part of your business and you won’t have the daily or monthly payment when business gets slow.