How can I reduce the total I pay on a long-term farm or business loan?

A long-term loan is paid out over a lengthy period of time. Generally, any loan that is going to be paid back over more than a year’s time is going to be viewed as a long-term loan. Long-term loans are set up to help people purchase costly pieces of equipment, land, or real estate. These items are items that the borrower could not afford to pay for all in one lump sum, so long-term loans can be very helpful.

A loan is the principal, or amount borrowed, plus interest. The interest rate, balance and term combine to determine the lifetime cost of a loan. It is important to consider the total amount paid, rather than the payment amount. This guide is for anyone who is considering a long-term loan and wants to know the basics: How they work, 3 worked examples, and ways to lower your overall cost.

How a Loan’s Principal and Interest Are Paid Down

Amortization refers to how a loan’s principal and interest are paid down over the life of a loan. Amortization schedules show the split between principal and interest payments, the balance over the life of a loan and the lifetime cost of a loan. It is important to understand this term because it helps in understanding how to pay off the loan and what it will cost over time. An amortization schedule breaks down a loan into periods (often monthly or yearly) and for each one lists the starting balance, the payment for that period, how much of that payment is interest, how much of that payment is principal, and what the balance is after that period.

A fixed schedule is the most common schedule, with a payment every period that does not change. This is the payment a lender quotes when you take out the loan. It depends on the amount borrowed, the rate, the term and how many payments a year. By changing any of these factors, the same amount borrowed will carry different loan costs.

In the formula for that payment, n is how many years the loan will run, and m is how many payments you make a year, so if you make payments monthly m = 12. If you want payments yearly, m = 1. Enter the rate i as a decimal. For example 3 percent = 0.03.

On each loan, part of the payment goes to the principal. The first part goes to the interest. Most long-term loans have a fixed interest rate. However, sometimes the rate changes as time passes. These are generally adjustable loans. The interest rates on adjustable rate loans are usually set lower than the rate on a fixed rate loan. As the borrower takes on the risk of the rate changing, they usually get the benefit of a lower initial rate. Adjustable rate loans can change from one period to the next, so it’s important for the borrower to keep track of the changes. This article is focused on fixed loans.

Most of these loans have interest calculated each period on the remaining balance at the start of that period. The balance of a loan declines as the principal is repaid. As the balance falls, the amount of the payment applied to interest falls, and the rest left for principal payment rises.

Principal paid equals payment minus interest. The principal part gets bigger each payment you make.

Let’s consider a hypothetical situation: You borrow $30,000 on a 5-year loan at 5 percent, payable annually (Table 1). The Beginning balance column shows the outstanding balance on the loan as each period starts; the first year it is the full loan amount and then the previous year’s ending balance.

The Fixed Payment column is the amount of each installment, here $6,929.24, paid five times. In year one Interest Paid uses the beginning balance, the rate and payments per year: $30,000 times 0.05 divided by 1 = $1,500.

As a loan’s term moves forward, the interest portion of the payment drops and the principal portion rises. By the final year, the interest on a payment will be very little. On this $30,000 loan, the interest in year one was $1,500; in year five it is $329.96. In year one the principal paid is $5,429.24, in year five it is $6,599.28.

The End of Period Balance column is the starting balance less the principal paid. The ending balance is carried over to the next period’s beginning balance until the final payment brings it down to zero.

Based on a $30,000 loan at 5 percent for 5 years, if you make annual payments your total loan cost will be $34,646.22; principal $30,000 plus interest paid $4,646.22. Changing the terms is one way to change the total loan cost.

Same $30,000 at 5 percent but extended to 10 years (Table 2). Ten annual payments means every payment is smaller. The total paid over the life of the loan is $38,851.37. That’s $4,205.15 more than you paid on a 5-year loan. Smaller payments pay down less principal. More interest results. Many times it doesn’t help to spread a loan payment out, because all you have done is lower your monthly payment. Check to see if you are paying less in interest over the longer term.

In a 30-year mortgage a payment is spread out even longer. As an example, in February 2023, the average fixed-rate 30 year mortgage rate was 7 percent in the state of Mississippi. Take a $100,000 mortgage at that rate (Table 3).

Complicated as the loan may seem, it can still be figured out from the same payment amount formula.

According to the formula, your payment is $665.30 a month for 360 months. You’ll pay $239,508.90 altogether; the interest is more than the $100,000 you borrowed, because of the long term and fairly high rate. The takeaway from that loan: Generally, if you borrow for a long time and at a fairly high rate, you may end up paying the lender more than the amount you borrowed, and that’s only on the interest!

How to pay less overall? Shop for the lowest rate you can find. Over the long haul, even a small reduction in your rate can mean big savings for you.

The top lever is a shorter term. A faster amortization schedule means you will pay down the loan faster with a higher payment each month, but far less paid over the life of the loan. You’ll see that in the 5 and 10 year term examples above; a longer term piles up the interest paid. While shorter terms come with the catch of a higher payment each period, they allow you to pay down more principal with each payment so less interest accrues overall.

How much can an early payoff of debt save you? Banks and other lenders make money by lending you money at interest. If you pay the lender back early, then they lose some of that profit. This is called a prepayment risk. Some lenders charge you a fee to cover that loss; that’s called a prepayment penalty. Other lenders may have no prepayment penalty. Before you make an extra payment, find out whether you have a prepayment penalty by asking the lender. However, if there is no prepayment penalty on your loan, you can cut a big chunk off your total interest paid by accelerating your amortization schedule.

Down payment means a payment a borrower makes at closing to lower the total amount borrowed. Paying less in down payment means less out of pocket at closing, but results in a higher balance borrowed. Interest is figured on principal; the less borrowed to start with, the less interest and total paid over the life of a loan. Put another way, a dollar not borrowed is a dollar never charged interest on; not just for one day, but for the whole term.

Before you borrow: running a business, any business including a farm is expensive. Sometimes it seems impossible to avoid a loan, but borrowing involves real costs. A loan will cost you, not only out of pocket up front. Your payment can eat up quite a bit of revenue over the life of the loan, especially if the total amount borrowed is high or the loan has a long term. Some things to think through first:

• The first is to see how big the loan payment will be based on your other cash flow.
• Then, consider if you have cash in today, and later, to pay the payments.
• Finally, compare a floating loan with a fixed loan and what the payment could be on each. You should ask about both because, while a floating loan may start lower, the payment can go up later.