By Meredith Wood
So you want to apply for a small business loan. You go through the application process, and the lender lets you know how much you can qualify for (this tends to be around 8 to 12% of your annual revenues). You may know the loan amount you want or need, but how do you know you can afford it?
Let’s look at the numbers you need to calculate to figure out the safest loan amount for your business.
To start, you need to understand your monthly payment. Then you can compare that monthly payment to your cash flow to determine the affordability of your loan.
How to Calculate Your Monthly Payment
To illustrate how loan payments are calculated, let’s use the following numbers to determine the monthly payment for a hypothetical fixed-rate loan:
- Principal Loan Amount: $10,000
- Term of Loan: 1 year
- Interest Rate: 15%
- Origination Fee: $500
What you owe each month is calculated by including three different components:
Your loan’s principal is simply the initial amount you borrowed from the bank or financial institution. In this example we borrowed $10,000, so that’s the amount of principal we’ll be paying back.
- Number of Payment Periods
The number of payment periods in your loan’s term will determine the amount of your individual principal payments. Typical term loans are repaid on a monthly basis, meaning in our example above, this loan has 12 payment periods, whereas a five year loan would have 60 payment periods, and so on.
For our hypothetical loan, we’ll be paying back our $10,000 principal over 12 periods, meaning our monthly payment on principal is $833.33.
Monthly Principal Payment = $833.33
- Interest Rate
Typically the interest rate provided by the bank will be stated as an annual percentage rate (APR). If your loan is paid on a monthly basis, you’ll need to divide the APR by 12 to determine the percentage of your principal loan amount you’ll be paying in interest each month.
So in our example, we have a $10,000 term loan with a 15% APR—so we divide that 15% by 12 to calculate a monthly interest rate of 1.25%—meaning our monthly payment on interest is $125.
Monthly Interest Payment = $125.00
Putting it all together, we’ll add up our monthly principal payment of $833.33 plus our monthly payment on interest of $125 to find that each month, we would owe the lender $958.33.
Total Monthly Payment = $958.33
What About Fees?
Loan fees vary widely between financial institutions and loan types. Your loan may have a fixed origination fee (like our example above), a fee that is a percentage of the principal, or no fee at all! It’s important to clarify what, if any, fees your loan will hold—and how they’ll affect your monthly payment—directly with your lender before signing the dotted line.
Origination fees are among the most common fees for term loans. Usually, origination fees are taken off the bat from the total loan amount. This means that upon signing our hypothetical loan agreement for $10,000, we would actually receive a check from the lender for $9,500. For this reason, origination fees don’t usually impact the monthly payment.
Calculating the Loan You Can Afford
Now that you understand how monthly loan payments are calculated, let’s determine what size of loan you can afford.
Determining the affordability of your monthly payment is a simple matter of ensuring that at the end of the month, after paying your other business expenses, you still have enough cash on hand to make your loan payment without being completely broke.
Here is a common equation that lenders recommend for calculating what size loan payment you can afford.
To use this equation, start with your typical monthly cash flow. (That’s the amount of cash you have on hand at the end of the month after paying for expenses like rent on your storefront, personnel costs, purchasing inventory, and/or payments on other debt.) Now divide that number by 1.5.
That total is the maximum monthly debt payment lenders would recommend that you take on in order to have enough cash left on hand to put back into your business.
Going back to our example loan above, let’s reverse the equation and see what kind of monthly cash flow we would need in order to afford that loan payment. In this case, we’ll be multiplying instead of dividing to determine our needed cash flow.
$958.33 x 1.5 = $1437.50
What do you think? Could your business afford this hypothetical loan? You’d need to compare this number to your monthly cash flow to be sure.
As Always, Talk to Your Lender
Now you’ve learned how to calculate the monthly payment and affordability of a basic, fixed rate term loan. You can also use a loan calculator like this one to calculate your monthly payment.
Of course, what we used is a hypothetical example, and every loan is different. So it’s important to talk to your lender about the specifics of your monthly payment. Some loan products even have weekly or daily payments. If this is this case, total all your payments in a month to get your “monthly” payment.
As well, your loan could have a variable interest rate, which could change your payments month to month. Merchant cash advances and invoice advances also have different structures for calculating payments and interest rate.
To get the most accurate information for your particular situation, ask your loan provider or a third party advisor to walk you through what you would paying on average each month for your loan and help you determine what you can afford.
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