Businesses that operate by lending money to business or individuals often have terms for the repayment of loans early. Sometimes there are fees the borrower must pay if they wish to repay early and sometimes there is no penalty at all. The question is, what are the actual financial implications for the lending business and what should be considered regarding such an event?
Here is a financial model for forecasting all aspects of a general lending business. There are lots of cool stuff in that template, including the usage of a credit facility to fund lending activity and assumptions about revenue recycling.
First, lets talk about IRR. This is the rate that you must discount the future cash flows at so the present value equals 0. If you look at the IRR of a loan from the perspective of a lender, the full amortization schedule will have an IRR for the lender. It is made up of the negative cash flow for the disbursement of the loan and the subsequent repayments. You can simply run the IRR function on those cash flows and get the internal rate of return for that loan.
Now, if the loan is fully repaid in period 25, the cash flows change but the IRR does not.
You can prove this to yourself by going into Excel or Google Sheets and entering the cash flows of a loan via an amortization schedule and choose arbitrary future months to repay the full balance.
Here is an example template I did in Google sheets that demonstrates this logic: https://docs.google.com/spreadsheets/d/1dnwPp66ebhWI8OlsEsDCqp4z9Lbvt0iN/edit#gid=68947601 (to edit this, hit File and Make a Copy) Note, the monthly IRR is shown and will always equal the interest rate of the loan divided by the payments per year, and when converting that into a total annual IRR, that will be a bit different than the actual APR.
Here is how to do it yourself:
Run the IRR function on the original loan amortization cash flows of the full term and then select an earlier month to have the loan be repaid and have the cash flows stop. Then run the IRR function on the new cash flows.
Holding everything else equal, the early repayment has no effect on the IRR. Essentially, the running balance of the loan is the amount needed to be paid at a given period to reach interest rate defined in the term of the loan. The difference is that even though the IRR is not different, the lending business is getting that IRR for less time and needs to redeploy capital.
From the perspective of the lender, early repayment of a loan can affect other aspects of the businesses financial performance:
- Interest Income: One of the key sources of revenue for a lender is the interest charged on a loan. If a borrower repays a loan early, the lender will receive less interest income over the life of the loan and now they need to go redeploy money and give up the locked in interest revenues they had.
- Reinvestment Risk: When a lender makes a loan, they have an expectation of receiving a certain amount of interest income over the life of the loan. If the loan is repaid early, the lender may have to reinvest the funds at a lower interest rate. This reinvestment risk can increase the uncertainty associated with the expected cash inflows, which can decrease the IRR.
- Prepayment Penalty: If the loan agreement includes a prepayment penalty, the lender will receive additional cash inflows if the borrower repays the loan early. The prepayment penalty will increase the overall cash inflows associated with the loan, which can increase the IRR.
Overall, the impact of early repayment on the IRR from the lender's perspective will depend on the specific terms of the loan agreement and the amount of any prepayment penalty. If there is no prepayment penalty, early repayment can reduce the lender's expected interest income and increase reinvestment risk, which can lower the IRR of the entire set of cash flows of all lending activity over the life of the business. If there is a prepayment penalty, early repayment can increase the overall cash inflows and potentially increase the IRR.
