If you're looking to secure a loan, you need to know how you'll repay it. Before borrowing funds for your business, it's smart to calculate what your monthly loan payment would be and whether you have the cash flow to support new debt.
Business loans offer small businesses a way to access funding for growth more quickly than they could by saving, but irresponsible borrowing could lead to a business's untimely demise. Here's how to calculate your expected loan payments before accepting funding to be sure your business can meet its debt service obligations.
Loan factors you need to know
To accurately calculate what you would owe 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 length of time over which the loan must be repaid with interest
- The interest rate of the loan, which is expressed as a percentage
"Small business owners should look closely at interest rate, payment frequency and any fees when evaluating loans," said Jeff Zhou, founder of Fig.
"Loan types vary. The best advice for a novice is to speak with their attorney or accountant about what loan type may be more advantageous to them," he said. "Critical is the deeper cash flow analysis the business owner must undertake to determine whether the business generates enough income to be able to make the loan payments comfortably."
Once you understand these loan factors, you can begin to calculate your monthly payment.
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How to calculate a loan payment
These formulas will help you calculate your loan payments. Before calculating 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.
Calculating an interest-only loan
An interest-only loan is calculated by multiplying the principal amount of the loan by the interest rate percentage, which yields the annual interest payments owed 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 five-year term and a 6% interest rate, you could easily figure out your monthly payment by applying the formula above, said Rex Freiberger, CEO of Discuss Diets.
To break this example down further, 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 yields a monthly interest rate of 0.5% (expressed as 0.005).
- Multiply the monthly interest rate of 0.005 by the loan balance outstanding, which in this case is $1 million. This yields a result of $5,000.
- Your monthly payment on interest for the first month of a $1 million small business loan would be $5,000.
If you wanted to understand the second month's payment, you could simply apply the same formula with the new balance of the loan. Here's an example:
- Multiply the new loan balance of $995,000 by the monthly interest rate of 0.005. This yields a result of $4,975.
- Your monthly payment on interest for the second month on the loan is $4,975.
- Repeat this process for each subsequent month, adjusting the outstanding balance of the loan accordingly, to determine your payment.
"If you pay down the principal of the loan, all you need to do is update the original $1 million with your new total principal and the calculation is good to go!" Zhou added.
Alternatively, he said, you could calculate your loan payments on a daily basis by applying a similar process known as "actual/365."
"The easiest way to calculate loan interest and payment for set amounts of time is to transform everything into days," Zhou said. "Interest rate is generally expressed as 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 need 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 amortization?
Amortization is the process of gradually paying off the principal 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 are talking about the percentage of the loan amount that is being repaid in each payment over a period of time, then you are talking about amortization," Jacobs said.
An amortization schedule could include the payments needed to pay down 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 "balloon payment" to cover the remaining balance on the 30-year loan, the principal balance of which has reduced over the five years of amortization payments.
"A borrower typically obtains bank financing to pay off the balloon payment to the seller and then would continue with a payment to the bank from this period forward," Jacobs said.
Calculating an amortizing loan
Amortizing loans are more complicated than interest-only loans. To calculate an amortizing loan payment, use the following formula:
Loan payment = Amount/Discount factor
- You must first determine the discount factor by 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 amount of the loan by the discount factor to determine your monthly payment.
"Amortization would depend on a number of facts, such as interest rate and repayment term," Jacobs said. "Depending on your industry, business loans might have a 20-year amortization. Banks typically won't spread the payments out over 20 years. … A five-year loan is more typical. The bank would still amortize the payments using a 20-year amortization schedule to keep the payments lower but require a balloon payment at the end of year five. … Generally, the business owner gets the loan rewritten at that time."
Checking your math with an online loan calculator
Online loan calculators are simple, free tools that allow you to easily check your work. While they are useful for calculating a rough estimate, they cannot always take the big picture into account. Therefore, you should use online loan calculators as a supporting tool rather than relying on them solely.
"Online loan calculators are convenient but make multiple 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, because you will want to pay early when the business is doing well and potentially extend the loan during less ideal times."
Here are some online loan calculators you can use to calculate your payments:
- Amortization calculator
- Equated monthly installment (EMI) loan calculator
- Interest-only loan calculator
- SBA loan calculator
- Vehicle loan calculator
How to manage loan payments
Before taking out a loan, small business owners must consider cash flow – their ability to service 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 revenue necessary to both meet your loan payments and keep your business running.
"The [small business] owner should be aware of the interest rate, term and amortization used to determine what their payment will be," Jacobs said. "They should also pay attention to how much a small change in the interest rate makes over the life of the loan. The SMB owner should also be prepared to understand how their business will generate the income necessary to make the loan payments."
By using these formulas to calculate your loan payments, you will be better positioned to repay them in a timely manner. You'll also be able to make sure your payments don't interfere with your ability to meet the necessary expenses for your business. Loans are a great tool for small businesses, but many entrepreneurs quickly find themselves with ballooning debt 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 uncertain, meet with an accountant who can walk you through the loan you're considering and offer financial advice on how to proceed.