Last updated on March 31st, 2020 at 03:24 pm
Every business needs financing to grow or expand and that’s done by acquiring loans. With loans, come interest rates on the amount borrowed when someone takes a loan from a bank or lending institution, regardless of its type, that loan must be repaid to the lender along with the interest accrued on it. But what do we actually mean by the term ‘interest’?
In simple words, interest is the fee for using a bank’s or financial institution’s money. It is essentially the lender’s profit for allowing the borrower to use their money. The repayment made on the loan has two components: principal and interest.
The principal portion reduces the amount of actual loan while the interest portion is the fee for using the loan. The interest for the next installment is calculated on the remaining balance.
Interest Rate Factors
Before we start calculating interest on business loans, we must first understand how much interest we are supposed to pay on a loan and how much should we borrow in the first place.
This is the initial amount of money a borrower is seeking from the lender. While going for a business loan, the trick is to ignore the amount that you want, and focus on the amount that you can easily pay back to the lender.
Term of Loan
Generally, any amount of loan taken for a period of more than 12 months is considered a long term loan. The interest is spread over a long tenure. It is more constantly in terms of actual amount paid in interest.
A loan taken for a period less than 12 months is considered a short-term loan. A short term loan is less costly but it means higher repayment amounts spread over a short tenure.
Loan Amortization/Repayment Schedule
Depending on the agreement with the lender, a borrower needs to make quarterly, monthly, or weekly repayments to the lender. There is compounding effect to loans that reduces interest when the payments are more frequent.
The above figure shows how compound interest climbs for a lender over a longer time period. The reverse is true for borrowers when they are repaying the loan. As the principal portion is reduced with each repayment, the amount of interest on the borrowed amount also reduces simultaneously.
Rate of Interest
The rate of interest on a loan depends on factors including the United States Fed Funds Rate, the spread of the Bank or the financial institution, and the cost of lending.
Historical data of Federal Funds Rate
The above chart shows a continuous rise in the Federal Funds Rate from 2016 to 2018. This means that a borrower will also be required to pay more in terms on interest as compared to the interest he was supposed to pay in 2016.
While calculating interest on a loan, the basic annual interest rate is used which is then divided by the number of days in the year, and multiplied by the number of days for which a particular repayment is made.
For example, if you took a loan of $100 at the rate of 10%. Your interest for one month will be as follows:
Interest for the year = 100 X 10% = 10
Interest for 1 day = 10 / 365 = 0.0274
Interest for 1 month = 0.0274 X 30 = 0.8219
Calculating Interest on Business Loans
If a business has to finance an inventory, buy a new location for business, or renovate, it usually acquires a business loan form commercial banks which can be paid using various payment plans. This loan is categorized as an amortized loan.
In such cases, the borrower is required to pay back a certain amount to the lender over time. At the end of the loan’s tenure, the business will not only have paid back the principal, but also the interest accrued on the loan.
It must be understood that any loan repayment based on the amortizing principal has two basic components: principal and interest.
With each repayment, a small part of principal is being repaid along with the interest amount. This effectively reduces the amount interest on the next payment and further subsequent payment.
Step-By-Step Calculation of Interest
Although you can use a business loan calculator for this purpose, it can also be done through simple mathematics. You will need the rate of interest, the number of repayments and the actual amount of loan. The formula is as below:
Amount of interest = (Rate of interest / number of repayments) X loan amount
- Divide the rate of interest by the total number of payments scheduled to be paid within a year. If you have agreed to pay on a monthly basis, then divide the interest rate by 12.
- Multiply the resultant amount with the amount of actual loan disbursed by the bank or the financial institution.
- You will arrive at the amount of interest that is due for payment during the first month.
For instance, you borrowed $10,000 to finance equipment at the rate of 8% for a year. The calculation of interest will be as follows:
(0.08 / 12) X 10,000 = 66.6667
This will be your interest payment for the first month.
For subsequent months, you will subtract the amount of interest from the monthly repayment to the lender. This will be your principal repayment amount for the month. When you subtract this amount from the original principal, you will arrive at the remaining principal after first month’s repayment. Use this amount for calculating the next month’s interest.
A simple repayment schedule for the above calculation is given below:
|Loan||Repayment||Interest||Principal Repayment||Remaining Principal|
The amount of interest paid to the bank is charged as expense while the interest earned on financing activities is shown on the revenue side in the Income Statement sample shown below.
Calculating Interest on ‘Interest Only’ Loan for Business
An interest only loan is different from a conventional loan in the sense that the payment made throughput the tenure goes towards settling of interest only. This means that the borrower will be required to pay the interest amount every month.
Subsequently, the amount of principal does not change and the interest amount also remains uniform through the tenure. The principal is repaid at the end of the tenure in a lump sum amount.
If you take the above example, you will be required to pay $66.6667 each month. At the end of the year, you will pay the last interest installment and the entire amount of $10,000 that you borrowed initially.
For interest calculation purpose, the interest only loan is quite simple. No calculation for monthly payment needs to be done.
The Bottom Line
There are several ways of calculating interest on a loan. It all depends on the type of loan you require for your business and how much repayment appetite you have. It is somewhat comforting to know that the interest can be charged to the expense account and is deductible from taxable income.
The key is to know how much you should borrow in order to repay the loan easily without causing unnecessary damage to your business.