How to Calculate Loan Payments

Loan payment factors

Before we get to the math, we need to define a few key business loan terms. In order to calculate what you would owe on an interest-only loan, you must first understand the following factors.

• Principal: the amount of funding you borrow and will pay back to the lender over time. 
• Term: the period of time over which the loan must be repaid, usually measured in months or years. 
• Interest: a percentage of the principal that you must pay to the lender as the cost of funding. 

“Small business owners should look closely at interest rate, payment frequency and any fees when evaluating loans,” said Jeff Zhou, co-founder and CEO of Fig Loans.

You should also understand the different types of business loans, said Erik Jacobs, a partner at Illinois-based law firm Cicero, France & Alexander, P.C.

“The best advice for a novice is to speak with their attorney or accountant about what loan type may be more advantageous to them,” Jacobs said. “Critical is the deeper cash flow analysis … to determine whether the business generates enough income to be able to make the loan payments comfortably.”

How to calculate a loan payment

Once you understand the terms and factors, calculating a business loan payment is much easier than you might think. All you need to know is the right formula for your particular loan, and then you can simply plug-and-chug. Here we’ll go through the math of an interest-only loan. 

Calculating an interest-only loan

With an interest-only loan, you only pay down the interest portion of the debt for the first few years. The annual payment on an interest-only loan is calculated by multiplying the principal amount of the loan by the interest rate. 

To calculate your monthly payments, apply the following formula:

Interest = Loan balance x (interest rate/12)

As an example, let’s calculate the monthly payments on a $1 million interest-only loan. 

• Divide the annual interest rate of 6% (expressed as 0.06) by 12 for the number of months in the year. This yields a monthly interest rate of 0.5% (expressed as 0.005).
• Multiply the monthly interest rate of 0.005 by the loan balance outstanding, which in this case is $1 million. This yields a result of $5,000.
• Your monthly payment on interest for the first month of a $1 million small business loan would be $5,000.

If you want to understand the second month’s payment, apply the same formula with the new balance of the loan. Here’s an example that builds on the first calculation.

• Multiply the new loan balance of $995,000 by the monthly interest rate of 0.005. This yields a result of $4,975.
• Your monthly payment on interest for the second month of the loan is $4,975.

Repeat this process for each subsequent month, adjusting the loan’s outstanding balance accordingly, to determine your monthly payment.

“If you pay down the principal of the loan, all you need to do is update the original $1 million with your new total principal and the calculation is good to go,” Zhou explained.

Alternatively, he said, you could calculate your loan payments on a daily basis by applying a similar process known as actual/365.

“The easiest way to calculate loan interest and payment for set amounts of time is to transform everything into days,” Zhou advised. “Interest rate is generally expressed as APR, which stands for ‘annual percentage rate.’ This can be turned into a daily interest rate by dividing the APR by 365. Then, all you need to do is multiply the total amount borrowed, the number of days [in the term], and the daily interest together to calculate how much interest you owe for that period of time.”

The advantage of an interest-only loan is that your payments are lower in the beginning. The downside is that you end up paying more interest over time than you would with an amortizing loan. 

How amortization affects loan payments

What happens if you have to make loan payments beyond covering the interest?

“If you are talking about the percentage of the loan amount that is being repaid in each payment over a period of time, then you are talking about amortization,” Jacobs said.

Amortization is the process of gradually repaying a loan through regular payments consisting of both principal and interest. At the beginning of the loan term, you might be surprised at how much of your payment is going to interest. The interest portion will be high because the loan balance starts out high. As you pay down the loan, the interest component shrinks until you get to the point where you are only paying the principal. 

“Amortization would depend on a number of factors, such as interest rate and repayment term,” Jacobs explained. “Depending on your industry, business loans might have a 20-year amortization, [but] a five-year loan is more typical.” 

Calculating payments on an amortizing loan

Computing payments on amortizing loans is a bit more complicated than interest-only loans. To calculate an amortizing loan payment, use the following formula:

Loan amount x [ (r/12)/ 1 – (1+(r/12))^–n]

where r is the interest rate (expressed as a decimal) and n is the total number of payments over the life of the loan. 

Let’s use our previous example of a $1,000,000 loan at 6% interest, except now it carries a term of five years, or 60 monthly payments. In that case, we would calculate the monthly payments like this: 

• Divide the interest rate of 0.06 by 12 months, written as (0.06/12) or 0.005.
• Subtract 1.005^–60 from 1. Now divide the result into 0.005. 
• Multiply the product of the first two steps by the loan amount to obtain a monthly payment of $19,332.80. 

Here’s what that looks like written out: 

$1,000,000 x [(0.06/12)/(1–(1+(0.06)/12)^–60] = $19,332.80

Understanding balloon payments 

Some business loans include what is known as a balloon payment at the end of the loan term. These types of loans are structured so your monthly payments at the beginning of the term are low. At the end, however, you will owe a larger lump sum, or balloon payment. 

For example, an amortization schedule could include the interest payments needed to pay down a 30-year loan over a five-year period. During the first five years, the principal balance is reduced through amortization payments. At the end of the five years, a borrower might owe a balloon payment to cover the remaining balance on the 30-year loan, the principal balance of which has been reduced over the five years of amortization payments.

Jacobs noted that many business owners get their loan terms rewritten before the balloon payment. Either way, make sure you understand the fine print of balloon payments so you don’t face a nasty surprise from shady small business lenders. You might also consider opening a business line of credit if you only need the money for a short-term project or an emergency. 

Checking your math with an online loan calculator

Online loan calculators are simple, free tools that allow you to easily check your work. For example, Business.com offers a loan calculator and debt calculator to help you estimate your borrowing costs. While this is useful for calculating a rough estimate, these tools can’t always account for the big picture. Therefore, you should use online loan calculators as a supporting tool rather than relying on them for everything.

“Online loan calculators are convenient but make multiple assumptions that are hidden from [small business owners],” Zhou said. “The biggest limitation of a loan calculator is the assumption of regular fixed payments. This rarely happens in reality, because you will want to pay early when the business is doing well and potentially extend the loan during less ideal times.”

How to manage loan payments

Before taking out a loan, small business owners must consider whether they have the cash flow to both service the debt and continue normal business operations. An otherwise healthy business can rapidly spiral into failure if its cash flow doesn’t cover debt payments. That is especially true in a rising interest rate environment, where payments on variable interest rate loans can fluctuate over time. 

“Pay attention to how much a small change in the interest rate makes over the life of the loan,” Jacobs warned. “The SMB owner should also be prepared to understand how their business will generate the income necessary to make the loan payments.”

By using these formulas to calculate your loan payments, you will be better positioned to decide which type of business loan is right for you. You’ll also be able to make sure your payments don’t interfere with your ability to pay the necessary expenses for your company. Loans are a great tool for small businesses, but many entrepreneurs eventually find themselves buried under debt they can’t afford. To avoid this all-too-common problem, do the math ahead of time and develop a repayment strategy. If you are uncertain, meet with a business accountant or financial professional who can walk you through the loan. 

Adam Uzialko contributed to this article. Source interviews were conducted for a previous version of this article.