If you are looking for a loan, you need to know how you are going to pay it back. Before borrowing funds for your business, it’s a good idea to calculate what your monthly loan payment would be and whether you have the cash to support new debt.
Business loans offer a way for small businesses to access financing for their growth faster than they could by saving, but irresponsible borrowing could spell the premature demise of a business. Here’s how to calculate your expected loan payments before accepting financing to ensure your business can meet its debt service obligations.
Lending factors you need to know
To accurately calculate what you should on an interest-only loan, you need to understand the following factors:
- The principal amount of the loan, which is the total amount you borrowed
- The term of the loan, or the length of time the loan must be repaid with interest
- The interest rate of the loan, expressed as a percentage
“Small business owners should take a close look at interest rate, payment frequency and fees when evaluating loans,” said Jeff Zhou, founder of figure.
You also need to understand the type of loan you are applying for, said Erik Jacobspartner at Cicero, France, Barch & Alexander PC
“Loan types vary. The best advice for a newbie is to talk to their lawyer or accountant about what type of loan might work best for them,” he said. “The in-depth cash flow analysis that the business owner must undertake is essential to determine if the business is generating enough revenue to be able to comfortably make loan repayments.”
Once you understand these loan factors, you can start calculating your monthly payment.
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How to Calculate Loan Repayment
These formulas will help you calculate your loan repayments. Before calculating your loan repayments, make sure you understand the type of loan. Calculating an interest-only loan, for example, is different from calculating an amortizing loan.
Interest Only Loan Calculation
An interest-only loan is calculated by multiplying the principal amount of the loan by the interest rate percentage, which gives the annual interest payments due on the loan. To determine your monthly payments, apply the following formula:
Loan repayment = Loan balance x (annual interest rate/12)
For example, if you take out a $1 million loan with a term of five years and an interest rate of 6%, you can easily calculate your monthly payment by applying the formula above, said Rex Freiberger, CEO of Discuss Diets.
To further break down this example, do the following:
- Divide the annual interest rate of 6% (expressed as 0.6) by 12, for the number of months in the year. This gives a monthly interest rate of 0.5% (expressed in 0.005).
- Multiply the monthly interest rate of 0.005 by the loan balance, which in this case is $1 million. This gives a result of $5,000.
- Your monthly interest payment for the first month of a $1 million small business loan would be $5,000.
If you wanted to understand the second month payment, you could simply apply the same formula with the new loan balance. Here is an example :
- Multiply the new loan balance of $995,000 by the monthly interest rate of 0.005. This gives a result of $4,975.
- Your monthly interest payment for the second month of the loan is $4,975.
- Repeat this process for each subsequent month, adjusting the outstanding loan balance accordingly, to determine your payment.
“If you repay the principal of the loan, all you have to do is update the original million dollars with your new total principal and the math is good!” Zhou added.
Alternatively, he said, you can calculate your loan repayments on a daily basis by applying a similar process called “actual/365”.
“The easiest way to calculate loan interest and payment for specific terms is to turn everything into days,” Zhou said. “The interest rate is usually expressed in APR, which stands for ‘Annual Percentage Rate.’ This can be turned into a daily interest rate by dividing the APR by 365. Then all you have to do is multiply the total amount borrowed, the number of days [in the term]and daily interest together to calculate how much interest you owe for that period.
What is amortization?
Amortization is the process of gradually paying off principal debt with regular payments plus interest. This subsequently reduces the monthly interest due, since the interest rate is applied to the new principal balance instead of the original amount borrowed.
“If you’re talking about the percentage of the loan amount that’s repaid with each payment over a period of time, then you’re talking about amortization,” Jacobs said.
An amortization schedule could include the payments needed to pay off a 30-year loan over a five-year period, Jacobs said. At the end of the five years, a borrower can offer a lump sum “lump payment” to cover the remaining balance on the 30-year loan, the principal balance of which has decreased over the five years of amortization payments.
“A borrower typically obtains bank financing to repay the lump sum payment to the seller, and then would continue with a payment to the bank from that time on,” Jacobs said.
Calculation of an amortizing loan
Amortized loans are more complicated than interest-only loans. To calculate an amortized loan payment, use the following formula:
Loan Repayment = Amount/Discount Factor
- First you need to determine the discount factor using the formula [(1+r)n] – 1]/ [r(1+r)n], where “r” is the interest rate (expressed as a decimal) and “n” is the number of payments per year.
- Divide the total loan amount by the discount factor to determine your monthly payment.
“The amortization would depend on a number of factors, such as the interest rate and the repayment term,” Jacobs said. “Depending on your industry, business loans can have a 20-year amortization. Banks will generally not spread payments over 20 years. … A five-year loan is more typical. The bank would still amortize payments using a 20-year amortization schedule to keep payments lower, but require a lump sum payment at the end of the fifth year. … Usually the business owner gets the loan rewritten at that time.
Check your calculations with an online loan calculator
Online loan calculators are simple, free tools that allow you to easily check your work. Although they are useful for calculating a rough estimate, they cannot always take into account the big picture. Therefore, you should use online loan calculators as a supporting tool rather than relying solely on them.
“Online loan calculators are convenient but make several assumptions that are hidden from [small business owners]“, Zhou said. “The biggest limitation of a loan calculator is the assumption of regular fixed payments. This rarely happens in reality, as you will want to pay earlier when the business is doing well and potentially extend the loan at less ideal times.
Here are some online loan calculators you can use to calculate your payments:
How to manage loan repayments
Before taking out a loan, small business owners need to consider cash flow – their ability to repay debt while maintaining operational expenses – in order to run a profitable business. You can only support a loan for working capital if you have the necessary income to both meet your loan repayments and operate your business.
“The [small business] the owner should be aware of the interest rate, term and amortization used to determine their payment amount,” Jacobs said. “They also need to pay attention to the impact of a small change in the interest rate on the term of the loan. The SME owner should also be prepared to understand how their business will generate the revenue needed to make the loan repayments. . »
By using these formulas to calculate your loan repayments, you’ll be in a better position to repay them on a timely basis. You will also be able to ensure that your payments do not interfere with your ability to meet the expenses necessary for your business. Loans are a great tool for small businesses, but many entrepreneurs quickly find themselves with bloated debt that they are unable to repay. To avoid this all-too-common problem, do the math up front and develop a repayment strategy. If you’re not sure, meet with an accountant who can explain the loan you’re considering and offer financial advice on what to do next.