The vast majority of small business owners need ways to fund their small business. It’s just a reality of entrepreneurship.
Without adequate capital, you can’t operate effectively, execute growth strategies, and achieve your long-term goals. Business loans are one of the main sources of small business funding and usually come from traditional banks, credit unions, and alternative online lenders.
While it can be easy to just look at the principal amount you owe plus interest rate, it’s important to understand the additional dues and fees that often come with taking a loan. Understanding the true cost of your business loan will enable you to choose the financing product that suits your company and is affordable.
Here’s what you need to know about calculating the cost of your small business loan.
Know your interest rate, but pay attention to APR
By definition, interest rate is the amount charged by a lender to a borrower. It’s expressed as a percentage and can be variable or fixed.
A variable interest rate means rates change over time as market rates shift, while a fixed interest rate is locked in when the loan is taken out.
Interest rates tell you what you’ll pay to borrow money, but they don’t really fully disclose the cost of a loan. It’s the annual percentage rate (APR) that details all the costs of borrowing, as it includes the interest rate plus factors like origination fees.
So, for instance, the interest rate on your $300,000 term loan from a bank could be 8%, but a 1% origination fee means you have an extra $3,000 in expenses. The loan APR factors in the interest rate as well as that extra $3,000, while the interest rate won’t.
How to crunch the numbers
The idea is to calculate your APR. This will give you an exact number of how much a financing product will cost.
To accurately crunch the numbers, you must include your interest rate and any fees. The good news is that there are many business loan calculators available to you online.
So, let’s go over an example of how to figure out your APR:
- Write down your loan amount, loan term, interest rate, and fees. For this example, let’s say you borrowed $100,000, with an interest rate of 6% and loan term of 5 years. There’s a $1,000 origination fee and $500 document charge. That equals $1500 in fees altogether.
- Plug all these numbers into your APR calculator. Make sure to specify if interest compounds weekly, monthly, quarterly, etc. Usually interest compounds along with the payment frequency, which, for instance, could be bi-weekly or monthly. For this example, payments are monthly and interest compounds on a monthly basis.
- You’ll see that your payment every month will be $1,962.28 and the total amount you’ll pay back over the 60-month term will be $117,736.76. The real APR is 6.621%. The cost of taking out that loan is $17,736.76, as the fees have been factored into the calculation.
Look at the loan amortization schedule
An amortization schedule illustrates how a loan is to be paid off over time. Loan providers will display this to you in your loan portal.
What a loan amortization schedule can show you is how feasible it is for you to make monthly payments while ensuring you don’t encounter cash flow problems. If revenue is solid, then you can even figure out ways to pay more and shorten that amortization schedule (just make sure there’s no prepayment penalty on your loan).
When shopping for and comparing loans, always look at amortization schedules. It will help you clearly analyze which loan suits your business needs more. As noted in the example, you want to be clear on if interest compounds weekly, monthly, quarterly, etc, as it will impact those payments over time.
Using your calculations to get the best loan for your business
When searching for a small business loan, research into the types of loans can help you find an appropriate financing product for your business. Ultimately, though, taking time to examine how much the loan will cost you in real dollars and how it will affect your budget and cash flow is what will enable you to pinpoint the most advantageous business loan.
Take your time and perform some good old math. You’ll find the loan your business can benefit most from. Then, all that’s left to do is put that capital to good use.