If you’re starting a business and you need some funding to get off the ground, a small business loan may be the way to go. Entrepreneurs can get loans from traditional banks, credit unions and third-party alternative lenders.
But borrowing from these institutions isn’t like borrowing from your mom and paying her back when you have the cash. When you repay a small business loan, you’ll end up paying more than the amount borrowed because of interest, amortization and fees.
Loan Rates
All small business loans come with interest that the borrower pays to the lender. Loans guaranteed by the Small Business Administration (SBA) are low-interest, but alternative small business lenders can charge high interest rates, especially for short-term loans. Loan rates can be varied or fixed. A borrower should choose a rate based on the market conditions at the time they get the loan.
Variable rates change over time as market interest rates shift. If market rates are high, a variable rate is a good idea because the loan rate will decrease if market interest rates drop.
Fixed rates lock in the market interest rate at the time a borrower takes out the loan. If market rates are low, it’s wise to get a fixed rate and maintain that low interest rate throughout the duration of the payment schedule.
Amortization Schedule
The loan’s term, or how long it takes to pay off, affects the overall cost of the loan because it determines how long a borrower pays interest. A payment schedule, or amortization schedule, is a plan for paying back a loan in regular monthly increments. Each payment consists of principal, or the actual cost of the loan, and interest.
For example, say an entrepreneur takes out a $100,000 loan for five years with a 5% interest rate. Each month for 60 months, she’ll repay $1,887.12 in principal and interest.
At the beginning of the term, a larger percentage of the payment is interest because lenders want to get their payments sooner to minimize risk. In this case, $416.67 of the first payment is interest and $1,470.46 is principal. With each payment, the percentage that is interest decreases and the part that is principal increases. In the final month, the borrower would pay just $7.83 in interest and $1,879.29 in principal.
Sample amortization schedule
| Month | Interest | Principal | Total Payment | Loan Balance |
| 1 | $416.67 | $1,470.46 | $1,887.12 | $98,529.54 |
| 2 | $410.54 | $1,476.58 | $1,887.12 | $97,052.96 |
| 3 | $404.39 | $1,482.74 | $1,887.12 | $95,570.22 |
| 4…57 | ||||
| 58 | $23.39 | $1,863.73 | $1,887.12 | $3,750.79 |
| 59 | $15.63 | $1,871.50 | $1,887.12 | $1,879.29 |
| 60 | $7.83 | $1,879.29 | $1,887.12 | $0.00 |
Source: amortization-calc.com
Fees
On top of monthly payments, borrowers have to pay loan fees. Most common are origination and guarantee fees, but some lenders will tack on additional costs. Borrowers have to pay interest on the fees that are added to the loan rate, so avoid high fees at all costs.
Origination fee – Lenders charge borrowers this fee for processing a loan application and other administrative work involved. It’s taken as a percentage of the total loan, for example, 1% of a $100,000 loan.
Guarantee fee – For SBA-guaranteed loans, lenders pay the government a portion of the amount guaranteed. Many lenders pass on part of this cost to the borrower.
To fully understand the long-term cost of your loan, look at the effective annual percentage rate (EAPR), which includes the fees and compounded interest you’ll pay each year. Like apples-to-apples, this number is helpful to compare loans from different lenders to determine the loan package that’s best for your wallet.
Seed money illustration via Shutterstock.
The post Small Business Loans 101: Calculating the True Cost of Borrowing appeared first on NerdWallet Credit Card Blog.
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