Why do we have to pay a fee for paying off our loans?

By February 27, 2018Factoring, Finance

Borrowing money is a very useful way to accomplish professional goals, pay off unexpected expenses, consolidate and pay debts, buy a car, a house, or whatever your heart desires. However, choosing the tenure that best works for you, may prove to be a hard-to-make decision; for example if your personal economic situation changes, say, for instance if you get a better paying job, have some extra bucks in your pocket and would like to pay off your loan faster. In this case, something that might seem like an advantage, could work against you, because contrary to what you may think, lenders (any institution authorized to provide loans) will normally charge what is known in the industry as a prepayment fee when you pay your loan early or when you refinance it. But before we get started, let’s review some basic concepts that will help you understand how this works.

  • Interest rate: This is the proportion of a loan that is charged as interest to the borrower, usually expressed as an annual percentage.
  • Posted rate: The publicly announced interest rate by lenders.
  • Actual rate: Final rate agreed between lender and borrower.
  • Tenure: Time in months between the loan’s issuance (disbursement) and its closure.
  • Mortgage: Legal agreement in which a financial institution lends you money at interest in exchange for taking the title of the debtor’s property up until the debt is fully paid.
So, why charge a penalty for getting their money back sooner?

That said, the idea that the loan issuer will be happy if you pay your obligation sooner than agreed proves wrong and here’s the reasoning behind this fact:

  1. Behind your loan, there are investors and lenders that rely heavily on the fact that you’ll be making payments over the term agreed on the contract. When you pay off your loan, these 3rd parties will simply see less money coming in than expected, and thus the prepayment fee is intended to make up for this.
  2. Normally loans are secured and come with a fix interest rate. Therefore, it’s not viable for lenders to refinance your loan when, for instance, the interest rates go down and you want to take advantage of them, as they expect to get the interest at the rate that was originally agreed.
  3. The longer you have the loan, the more interest you pay, and therefore, the more profit the lenders make.
The rule of 78, what is it?

This is simply a method used by lenders in which the interests of a loan are weighted towards the first payments and decreased at the end of it. This method aims to discourage the customers from paying off the loan or at least making sure it’s not done that early.

This procedure is very popular when it comes to car loans. Legally, lenders can not apply this approach on loans with terms longer than 5 years.

What to do then?

Here are some recommendations to take into consideration before getting a loan that will help you avoid any headaches.

  • When signing up for a loan, you’ll certainly have to go through a lot of paperwork that can turn out to be overwhelming. However, it’s imperative to read the contract´s fine print, as the exit fees will be there. Make sure you understand all the terms including the interest rate that will be used to calculate any penalty (if applicable) for paying off your loan and all the other clauses.
  • Based on your income, make sure the term you’re agreeing to suits your pocket. Thus, you won’t have to refinance or pay it off.
  • If you get to negotiate the interest rate and your lender approves a rate lower than the posted rate, take into account that the latter will be used to calculate any penalties for breaking the contract.
  • Watch out for prepayment penalties, especially when we talk about mortgages. Depending on the type of loan, banks have a particular policy for penalties. Prepayment fees on a mortgage are normally 80% of six months of interest, nonetheless, make sure you ask and do not rush to sign the contract.
  • Compare the penalties to that of various loan issuers and choose the one that best fits your needs.
  • Take into account that exit fees are mostly beneficial to the lender, not to the borrower.

It’s important to understand that the type of loan, the tenure, the interest rate and all the terms and conditions are specific to each person’s needs and capabilities, so the bottom line is “do not rush to make your decision, instead take into consideration your particular circumstances and the broad variety of options available on the market”.

The financial services market is a fast-changing one and now we have access to non-traditional funding methods. One of this revolutionary options is factoring, a simple, yet very useful and effective way to address your financing needs and improve your cash flow.

How does factoring work and how can you benefit from it?

First of all, let’s go over the basics.

  • Client: A person/company that sells their invoices to a factor
  • Factor: A factoring company
  • Debtor: Also known as customer, is the payer of the debt
  • Invoice: A bill that needs to be collected from the debtor

The way factoring works can be summarized in these 4 simple steps:

  1. You sell your invoices to the factor
  2. You get an advance from the factoring company of up to 95%
  3. The debtor pays within 30-60 days. The invoice is collected by the factor directly, lessening the burden of having to collect yourself.
  4. You can get the rebate (rest of the debt minus the commission) once the debt is fully collected

Factoring is especially of benefit for companies that are still growing and have liquidity problems, since you’ll get funding almost immediately and don’t have to deal with the debtor trying to get your money back. So if your company is thriving and the banks either won’t lend to you or the interest rates are not competitive, don’t think twice about it, factoring is your best bet!