How do I calculate the monthly payments on a business loan?

You’re taking a business loan to grow your business, but you’ll need a plan to pay it back. This article shows how monthly payments are calculated.

Getting a great small-business loan is one thing. Being able to afford the payment is quite another. Work out the monthly loan payment, then do your cash flow and see if you can make the payment - responsibly. One of the biggest reasons for failure in business is irresponsible borrowing.

Loan Lingo

Small-business loans can be confusing with their different terms and jargon. Below we define loan lingo, then step through the math of calculating your monthly payment. It is not as hard as you might imagine.

• Principal loan amount - The dollar amount borrowed from the lender. The principal balance is what the borrower borrows (and owes) the lender.
• Term length: The length of time you have to repay the money, plus interest and fees.
• Interest rate - The percentage of the principal (loan amount) charged for borrowing. The rate determines how much money the lender receives from the borrower on top of the amount loaned.

You should look closely at the interest rate, how often you need to make payments and any fees you may incur, says Fig Loans CEO and co-founder Jeff Zhou.

There are different types of business loans, which can be confusing to first-time borrowers. Depending on the complexity, it may be wise to talk to an attorney or accountant, says Erik Jacobs, judge of the 17th Judicial Circuit, Boone and Winnebago Counties. Ultimately, a strong cash flow analysis will show whether the business really brings in enough money to cover loan payments comfortably.

Calculating the Monthly Payment

Now that you have a solid understanding of the jargon, it’s time to figure out exactly how much your monthly payment will be. Don’t worry. It’s not rocket science.

Start with interest-only loans, which are easier than you might think. Basically, you only pay the interest amount during the first several years of the loan. So the yearly payment simply equals the amount you borrow times the interest rate.

To get the monthly interest amount on an interest-only loan, simply use this formula:

monthly interest = loan balance x (annual interest rate / 12)

To figure interest only payments on a sample loan, let’s try a $1 million loan at 6 percent annual interest.

Six percent is 0.06. Divide that by 12 and the interest rate each month is 0.005, or 0.5 percent.

Take that and multiply it by the $1 million: $1 million x 0.005 = $5,000

The interest payment on the first month on a $1 million loan at 6 percent interest is $5,000.

Whenever you pay down some principal, just swap the smaller principal into the formula and recalculate, Zhou says.

Another way to determine interest payments is by the day instead of by the month. The method is known as actual/365.

The simplest way to calculate interest rates would be to convert everything into days, says Zhou. Find the APR (annual percentage rate) and divide it by 365 to get the daily rate. This shows the daily rate and gives you what you need for the equation of interest = amount borrowed x number of days x daily rate.

Interest-only loans sound like a wise deal, and they can be in the early years of the loan. But the drawback is that over time you end up paying more interest than if you did an amortizing loan from the start.

What do you do if your loan doesn’t just require the interest each month, but also some of the principal balance as well?

This process of repaying part of the principal balance each month is called amortization, Jacobs explains.

Amortization means that you pay back the loan with monthly installments, and each month’s payment includes some principal balance. In the early months you pay a surprisingly large percentage to interest compared to principal because the balance is still huge. As time passes and the balance falls, a smaller percentage of each monthly payment goes toward interest.

The length of time for which the loan amortizes can depend on the rate and term. For example, some loans amortize over 20 years, though a five-year loan is more typical, Jacobs explains.

Calculating the monthly payment on an amortizing loan requires a few more steps, so grab a pencil and paper and get ready to do a little number crunching.

The formula may look complicated, but don’t let that scare you. Take it one section at a time: Monthly payment = P x (r / 12) / [1 - (1 + r / 12)^-n], where P is the principal, r is the yearly interest rate as a decimal and n is the number of payments.

Back to our $1,000,000 loan at 6 percent interest. Let’s say you want to pay it back over five years. That means 60 monthly payments.

Then convert the yearly interest rate (6 percent) into a decimal. That’s 0.06. Now divide that by 12 to determine the monthly interest rate. That’s 0.005.

Then raise 1.005 to the power of -60 (that is 1.005 with -60 as the exponent) and subtract that from 1. Divide the monthly interest rate (0.005) by this, then multiply the result by the loan amount.

The monthly payment on this $1,000,000, 6 percent amortizing loan is $19,332.80.

This is the entire equation written out: $1,000,000 x 0.005 / [1 - (1.005)^-60] = $19,332.80

Sometimes a business loan isn’t repaid with monthly payments over a number of years. Sometimes there’s a final, lump sum payment that needs to be made. It’s called a balloon payment. Borrowers can think of a balloon payment as the last payment, while the smaller payments are the earlier ones that continue in that payment pattern.

Here’s a sample scenario: Sometimes a loan is amortized over 30 years. What this means is, in your monthly amortization, you are paying down the loan as if you had 30 years to repay it, but you only make payments for five years. Then the remaining balance comes due all at once, like a big balloon.

Many business owners will try to refinance the loan or rewrite the terms before the balloon is due, Jacobs says. Make sure you read the fine print when taking out a balloon loan. A dishonest lender could surprise you with a balloon payment. Sometimes a line of credit can be a more useful tool for short-term or emergency needs.

Online Calculators Are Useful but Not Perfect

If you have done the math and think you’ve calculated the monthly payment on your business loan, congrats. But why not use an online calculator to double check your number crunching? An online calculator is only an estimate. Online calculators can give you some idea, but don’t forget that free online tools only tell you a piece of the story. Use calculators to check your math, not as your sole source.

Calculators hide the assumptions they use, but the most important assumption that an online calculator makes is that you make the same flat payment every month for the entire loan. But in reality a business might have to pay early during the good times and stretch out payments in lean times.

Keep in mind even a healthy company can go under when too much of its cash flow is lost to paying off debt. Also, on a variable-rate loan, that payment can get big over time. Rates go up, payments do too.

Even a slight rate increase can have a huge effect over the life of the loan. You need to know exactly how the business is going to make the money to pay it back, says Jacobs.

Knowing these formulas can help you pick the right loan for your business. But don’t let yourself get in over your head. Loans can be valuable tools for small businesses, but many a time, they are just a recipe for debt. Many business owners end up with a loan they can’t afford. Plan ahead or seek help, but don’t wait to do the math until after you sign the dotted line.