If you are looking to get a loan, you need to know how you will pay it back. Before borrowing money for your business, it’s a good idea to calculate how much your monthly loan payments would be and whether you have the cash on hand to fund new debt.
Business loans provide a way for small businesses to access finance for growth faster than they could by saving money, but irresponsible borrowing could lead to 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.
Loan Factors You Should Know
To accurately calculate what you should have 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, which is expressed as a percentage
“Small business owners should take a close look at the interest rate, frequency of payments, and potential charges when appraising loans,” said Jeff Zhou, founder of Figure.
“The types of loans vary. The best advice for a novice is to speak with their lawyer or accountant about the type of loan that might benefit them the most,” he said. “The more in-depth analysis of the cash flow that a business owner needs to undertake is critical to determining whether the business is generating enough revenue to be able to comfortably make loan payments. “
Once you understand these loan factors, you can begin to calculate your monthly payment.
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How to calculate a loan repayment
These formulas will help you calculate your loan payments. Before you calculate your loan payments, make sure you understand the type of loan. Calculating an interest-only loan, for example, is different from calculating an amortizing loan.
Calculate an interest-free loan
An interest-only loan is calculated by multiplying the principal amount of the loan by the percentage of the interest rate, which gives the annual interest payments due on the loan. To determine your monthly payments, apply the following formula:
Loan payment = 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 above formula, said Rex Freiberger, CEO. of Discuss diets.
To break this example down further, follow these steps:
- Divide the 6% annual interest rate (expressed by 0.6) by 12, for the number of months in the year. This gives a monthly interest rate of 0.5% (expressed as 0.005).
- Multiply the monthly interest rate of 0.005 by the outstanding 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 figure out the second month’s payment, you could just 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’re paying off the loan principal, you just need to update the original million dollars with your new total principal and the math is done! Zhou added.
Alternatively, he said, you can calculate your loan payments on a daily basis by applying a similar process known as “real / 365”.
“The easiest way to calculate interest and loan payment for specified periods 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 the daily interest together to calculate how much interest you owe for that period of time. “
What is depreciation?
Amortization is the process of gradually paying off primary debt with regular payments plus interest. This subsequently reduces the monthly interest owed, 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 is paid off 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 might offer a “lump sum payment” to cover the remaining balance of the 30-year loan, the principal balance of which has declined 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 period,” Jacobs said.
Calculating an amortizing loan
Amortizing loans are more complicated than interest-only loans. To calculate an amortizing loan repayment, use the following formula:
Loan Payment = Amount / Discount Factor
- You must first 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.
“Amortization would depend on a number of facts, such as the interest rate and the repayment term,” Jacobs said. “Depending on your industry, business loans can be amortized over 20 years. Banks generally do not spread payments over 20 years. … A five-year loan is more typical. annual amortization schedule to keep payments lower, but require a lump sum payment at the end of the fifth year. … Typically, the business owner gets the loan rewrite at this time.
Check your math with an online loan calculator
Online loan calculators are simple, free tools that make it easy for you to check your work. Although they are useful for calculating a rough estimate, they cannot always take the big picture into account. Hence, you should use the online loan calculators as a helping tool rather than just relying on them.
“Online loan calculators are convenient but make multiple assumptions that are hidden [small business owners]Zhou said. “The biggest limitation of a loan calculator is the assumption of regular fixed payments. This rarely happens in real life, as you’ll want to pay earlier when the business is doing well and possibly extend the loan for 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 must consider cash flow – their ability to pay off debt while maintaining operating expenses – in order to run a profitable business. You can only support one working capital loan if you have the income you need to both meet your loan payments and keep your business running.
“The [small business] The homeowner should be aware of the interest rate, term, and amortization used to determine their payment amount, “Jacobs said.” They should also be careful of the magnitude of a small change in the rate. interest over the term of the loan. The small business owner should also be prepared to understand how his business will generate the income needed to make the loan repayments. “
By using these formulas to calculate your loan repayments, you will be in a better position to pay them off on a timely basis. You will also be able to make sure 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 pay off. To avoid this all-too-common problem, do the math ahead of time and develop a repayment strategy. If you are not sure, meet with an accountant who can explain the loan you are considering and offer financial advice on how to proceed.