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Lock in a Rate of Return through Debt Repayment

By Michael Taylor

In the last entry on loan repayment, I promised to describe a situation in which, as a small business owner able to pay debt early, you can lock in a good rate of return on your money.

The first and most obvious way is the direct return on money you get on early pre-payment of debt owed to banks such as lines of credit, term loans, or credit card debt. This is easy to calculate: In essence, pay off your 8% business loan and you lock in an 8% return on your money, without risk.

Clearly, the more expensive your debt, the better return on your money you receive for paying it off early. If you’re paying credit card rates of 18% or higher, the best way to ‘beat the market’ and earn a return of 18% (without risk!) is to get that debt paid right away. If your business is not otherwise earning a rate of return above that 18%, you are locking in a loss on your capital. Most businesses cannot consistently or risklessly earn above an 18% return on capital, which means most businesses should not carry balances at high rates of interest.

There’s another way to get a great rate of return paying off loans early, if you have the special situation of owing money to a private lender or a specialty finance company.

Here’s the key thing you need to know: Most every non-bank lender has a price, below the total amount owed, at which they would allow your business to repay the debt early. Your goal is to find out for how much, and when, they would take a discount.

The special circumstances vary on how the debt came about, but believe me, every one of these lenders has a discounted price known only to them on their loan to your small business.

The debt might be a note carried back by the previous owner of the company from whom you bought the business. It might be from a real estate investor who liked offering you financing because she had extra cash and didn’t mind earning a decent return for the loan.

Sooner or later, your private lender will have need for cash today – whether it be to buy a new business, a new property, or just to reduce exposure to your business - and they would accept less than the total amount owed.

Incidentally, this scenario comes with a don’t-try-this-at-home warning: Banks generally will not discount their loan to your small business, unless they think you are in serious trouble. Do not try to negotiate a discount like the above example unless you are in that situation, as banks don’t take too kindly to the suggestion of a discount. Chances are they will immediately start adverse action that will cost you more in the end.

But, if you’ve got the ability to pay off the debt early or can refinance the debt through a bank, you should strategically offer to do so with the private lender at a reduced amount. Maybe you just let your lender know that anytime they want the money back early, you could probably accommodate them for, say, 85% of principle. No rush, you say, just letting you know that if you need the money back early, it’s available.

How good is your rate of return if you’re able to get a discount like that? It helps to use the mathematics of a specific example to illustrate the rate of return discussion:

Let’s assume you owe $100,000.00 at 8% interest over the next 3 years. If you can pay the debt at 85% of the remaining balance today, you can effectively lock in not 8% (the automatic Rate of Return of repaying your debt) but instead 14.58% for the next three years.

There are very few opportunities in the financial world in which you can earn 14.58%, without risk. If you pay off the debt entirely you actually reduce risk. If you refinance through a bank, at least you lock in savings.

If you owe money to a private lender or specialty finance company, it doesn’t hurt to try to get a discount if you can. The rate of return possible through discounting the debt makes it worth the effort.

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