Most small businesses are unable to make major purchases without taking out business loans. Understanding how the loan process works is important for business owners and others looking to take on a loan. This includes having a clear understanding of principal vs interest.
Businesses must pay interest, which is simply a percentage of the amount loaned, to the institution that loans them the money. These loans could be for vehicles, buildings, or other business needs. The amount loaned is what is called principal, or the actual loan amount.
How Interest Is Calculated for a Business Loan
Banks actually use two types of interest calculations:
Simple interest, which is calculated only on the loan principal vs interest accrued on amount of the loan, which is how compound interest is calculated. In other words, on both the principal and on interest earned.
Simple interest is the simplest formula to calculate. Here’s an example of simple interest where “n” represents the life of the loan:
Principal × interest rate × n = interest
To show you how simple interest is calculated, assume that you borrowed $10,000 from the bank for a building loan at five percent (0.05) interest for four years. When the loan principle is repaid after four years, the interest accrued is two thousand dollars, or $10,000 × .05 × 4 = $2,000.
Notice that the total interest rate on the balance vs interest paid is determined by the life of the loan. In theory, if the loan were repaid in full in only two years the total interest accrued would only be $1,000.
Compound interest, on the other hand, is not computed on just the principal vs interest accrued like the previous example. The interest per period (monthly or annually) is based on the remaining principal balance plus any outstanding interest already accrued. The total loan interest compounds over time.
Types of Business Loan Repayment Plans
You and your lender can potentially arrange for a number of repayment plan options. Let’s say you borrow $10,000 with interest at the rate of 10% a year. Here are some of the more common business loan repayment possibilities:
Lump sum repayment: You might agree to pay principal and interest in one lump sum at the end of, say, one year. Under this plan, after 12 months you’d pay the lender $10,000 in “principal”, or the borrowed amount, plus $1,000 in interest.
Periodic payments of principal and interest: You would repay $2,500 of the principal vs interest amounts that decrease at the end of each year. Under this plan, your payments would look like this:
Year one you pay $2,500 of the principal plus $1,000 interest.
Year two you pay $2,500 of the principal plus $750 interest.
Year three you pay $2,500 of the principal plus $500 interest.
Year four you pay $2,500 of the principal plus $250 interest.
Amortized payments: This type of arrangement requires you to make equal monthly payments so that principal and interest are fully paid in a certain time period. Under this plan, you’d have an amortization table to figure out how much must be paid each month to fully pay off a $10,000 loan principal vs interest of 10%.
Each of your payments would consist of both principal and interest. At the beginning of the repayment period, the interest portion of each payment would be larger and decreasing towards the end.
Know What You Owe
To sum up, a business loan is a simple matter of paying the full amount of the principal vs interest amounts, which can vary not only in the percentage applied, but in the manner it’s calculated. Once you are ready to move forward with the loan process, be sure you know how much the interest is going to add up to in an actual dollar amount over the life of the loan.