Foreclosure Charges On Business Loans

If your business is doing well prepaying a business loan and getting free from debt seems like an attractive option. Explore our article about Foreclosure Charges on Business Loan.

17 Oct,2022 11:04 IST 20 views
Foreclosure Charges On Business Loans

The most basic requirement for an enterprise is financial resources, not just to cover general expenses for office and administration needs but also to give shape to a future expansion project such as expansion in production capacity or increased office space to house additional employees and so on.

This requires a business venture to either tap into existing or new source of equity or debt capital. The latter is often the more efficient form of capital source, especially if the interest rate cycle in the country is at the lower end of the curve.

This is because debt is ‘non-dilutive’. In simple words, it doesn’t decrease the ownership percentage of the business owner as external equity does.

Indeed, an entrepreneur can also take debt at a personal level via a gold loan or a plain vanilla personal loan. But lenders offer tailored loans for a business and unless the enterprise is too young to take a loan, one should opt for a business loan.

Both banks and non-banking finance companies (NBFCs) offer business loans. Broadly, these are of two types: secured and unsecured. In the case of the former one needs to furnish a collateral. The latter, as the name suggests. comes without any such requirements.

However, in both the cases, the borrower needs to pay back the entire sum availed along with the associated interest charges depending on the period for which it has been taken and not just at the end of the period but in periodic instalments, which is usually a monthly affair and hence the term equated monthly instalments (EMI).

Prepayments

But what if the borrower gets an unanticipated cash inflow due to additional demand for the product or service it offers in the market? This leads to a surplus in the accounts.

A business can choose to use this money for future expansion. But if the enterprise has previously taken a loan, be it secured or unsecured, it may be a prudent decision to prepay part or the entire outstanding loan as it helps a business go debt free and save on interest charges.

This is because usually the business has a current bank account that doesn’t bear any interest. Moreover, the business would earn less if it puts the money in short-term deposits compared to what it pays as interest on the existing loan on the books. So, instead of continuing with the loan and getting low returns on the surplus cash even if put in fixed deposits, it is better to prepay part or all of the loan as applicable.

On the other hand, prepayments mean a loss of interest income for the lenders. To make up for this loss, banks and other lenders such as NBFCs impose a fee known as foreclosure charges on the outstanding loan amount.

Foreclosure Charges

Typically, lenders have a minimum cut-off period within which the borrower cannot prepay the entire loan. Post that period, the borrower can use their surplus to pay back part or the entire sum outstanding after paying the foreclosure fee.

These charges differ across lenders and can go as high as 7% of the outstanding principal amount borrowed.

The charges and terms of repayment also vary based on the loan terms agreed upon initially between the borrower and the lender. So, some lenders may allow a borrower to prepay up to 25% of the total outstanding loan amount without any foreclosure charges while others may charge a nominal percentage.

In addition to the actual foreclosure charges, a prepayment also entails a Goods and Services Tax component.

Charges And Mechanics Of Foreclosure

The EMI that a borrower pays every month usually includes a portion of the interest expense as well as the principal loan amount, which keeps reducing every month as the instalments are paid back.

The foreclosure charges are essentially calculated based on the portion of the original loan amount that stands unpaid as on date and the loan tenure. So, the higher the loan amount outstanding and longer the pending tenor of the loan, higher will be the actual foreclosure charge in absolute term.

As a result, if one has taken a five-year unsecured business loan and intends to pay back the sum after three years it would come with a higher foreclosure charge as against a scenario where the same business loan is paid back after completing four years.

Borrowers can easily work out the actual foreclosure charges by simply entering the variables given their own outstanding loan amounts in online calculators available with most lenders.

The borrower needs to approach their lender with the plan to prepay part or the entire outstanding business loan who will in turn inform about the charges. Once the borrower pays back these charges, either through an online channel or via a demand draft or cheque, the loan is deemed paid and the loan account closed. Thereafter, the lender provides a loan closure note for future use.

Conclusion

Prepayment, whether partly or fully, helps borrowers save interest cost but at the same time it leads to a loss of interest income for the lender. To compensate for this loss, lenders impose a foreclosure charge on the borrower. The actual percentage and amount vary from lender to lender based on the loan agreement signed initially but usually, the fee is higher if the loan is being paid back sooner rather than later and the outstanding amount is higher.

IIFL Finance charges a low foreclosure fee of just 4% if the prepayment is made after the initial two years of the loan being availed. Unlike many lenders who do not allow payments in the first six months of the loan, IIFL Finance allows that too, though with a marginally higher foreclosure charge.

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