So, how do you calculate the true cost of your business loan? The good news is, this isn’t an unanswerable question; there are plenty of useful business loan calculators that can help you determine your payment schedule, total loan cost, and more.
That said, it’s still important to learn the fundamentals of calculating a business loan’s cost. While calculators can give you numbers, you still need to understand how to use those numbers to make good business financing decisions.
In this post, we’ll explain what goes into calculating your business loan’s cost. We’ll also demonstrate how to determine your payment schedule and the impact of fees on your loan cost.
Calculating the Total Cost of Your Business Loan
To keep things simple, we’ll assume you’re obtaining a fixed-rate business loan. We’ll touch on variable rates and interest-only periods later.
With a fixed-rate loan, to calculate your loan cost, you need the following inputs:
- Loan principal, or the total amount of your debt.
- Interest rate
- Fees and/or discounts
- Loan term
- Prepayment penalties (if applicable)
All of these inputs should be fairly easy to obtain. However, you must be especially diligent about obtaining an accurate number for your fees. If you’re unsure, ask your business lender to clarify.
Once you have these inputs, you can use a
business loan calculator to determine the total cost of your loan, excluding fees (such as origination fees). With that number, you’ll then need to add fees (or subtract discounts) to come up with the total loan cost.
This number is especially useful when you’re evaluating the return on investment of potential projects. Suppose, for example, that you take out a five-year, $100,000 loan with an interest rate of 10 percent and fees of $2000. Over five years, your total cost (interest and fees) for that $100,000 loan is $29,482, or 29.48 percent.
Therefore, to break even on that loan amount, you must earn an ROI on those loan funds of at least 29.48 percent.
Calculating the Cost of Variable-rate Loans
Calculating the cost of variable-rate loans requires additional steps.
With a variable interest rate, the business loan’s interest rate is based on an
underlying benchmark rate that changes periodically. Due to this, you won't fully know much a variable-rate loan will cost until it reaches full maturity.
To approximate the total cost of a variable-rate loan, you can calculate your cost based on multiple scenarios.
For example, it’s entirely possible that your rate never changes. In that case, you could use the same method for calculating the cost explained in the previous section.
However, let’s say you also want to project your loan cost if your rate changes at the end of the third year of your loan. To do that, you’d need to take an extra step, which we'll detail below:
Let's say that you have a five-year, variable-rate loan of $100,000 with an interest rate of 10 percent. To calculate the cost of the loan if the rate increases by 2 percent at the end of year three, you’d again use a calculator. Except this time, you’re going to do two calculations:
In the first, you’ll enter the details of your loan:
- Loan term: five years
- Interest rate: 10 percent
- Loan principal: $100,000
Then, you’d look at the amortization schedule and find the total interest and the balance of your loan at the end of three years. In this case, the balance would be $44,303 and the total interest would be $22,917 at the end of year three.
Make a note of the total interest and then enter the new details of your loan:
- Loan term: two years
- Interest rate: 12 percent
- Loan principal: $44,303
Total interest on this calculation comes out to $5748. Next, add that total amount ($5748) to $22,917 to get a complete interest cost of $28,665.
You can use these steps to project as many scenarios as you like on a variable-rate loan. Here’s a recap of how to do it:
- Enter your original loan details into a calculator.
- Use the amortization table to look up your loan balance and total interest cost in the period in which your original rate changes.
- Enter your remaining loan balance, interest rate, and remaining term into a calculator.
- Repeat as necessary
To get your total loan cost, you’ll need to add any fees into the total as well.
Factoring Prepayment Fees into Your Payment Schedule
In the previous section, we touched on a very important concept: amortization schedules. A loan amortization schedule shows you the following over the life of the loan:
- The reduction of your debt
- Your breakdown of interest and principal paid
- Your loan balance
The business loan calculator linked to earlier provides an amortization schedule. You can use this schedule to guide calculations on the cost of refinancing, variable-rate, and interest-only loans.
Amortization schedules are also useful for calculating prepayment fees or discounts.
Often, prepayment fees are based on your loan balance or
prepayment amount. In those cases, an amortization schedule helps you determine what your loan balance or prepayment will be in a given period.
For example, suppose your loan comes with a prepayment fee of 5 percent of your remaining loan balance. Using an amortization schedule, you can look up your remaining loan balance in the period you plan to prepay. Then, to determine your prepayment fee, you multiply 5 percent by the loan balance indicated in the amortization schedule.
Conclusion: Be Wary When Comparing Loan Costs
What’s tricky about comparing loan costs isn’t the calculations; it's ensuring you’re comparing apples to apples. For example, assuming all else is equal, you’ll pay significantly more in interest on a long-term vs. short-term loan.
Also, APR, which was meant to make comparing loan costs easy, can be misleading. APR is a rate that represents a loan’s interest rate plus fees. However, business lenders have discretion as to which fees they include in their APR calculation. Therefore, APRs on business loans aren’t always apples to apples, so you should ensure you're receiving an accurate number.
The bottom line is, when calculating and comparing total loan costs, don’t take things at face value. Ask questions until you understand the timing and amounts that you’ll owe when you obtain a loan.