There are always costs associated with borrowing money. If you're considering a business loan, you need to understand the additional expenses beyond the principal loan amount, as they'll impact your upfront costs and monthly payments.
Here are some of the different loan costs you might encounter and how to calculate the total cost of a prospective loan.
[Read more: How to Apply for a Small Business Loan for Your Startup]
What are business loan costs?
The primary cost of taking out a loan comes in the form of interest payments. Interest is the cost of borrowing money, typically represented as a percentage of the total amount of money borrowed. For example, a 7% interest rate means you'll pay an additional 7% on the current balance of your loan directly to your lender.
Depending on the lender you use and the specific type of loan product you have, you may also have to pay some or all of these additional loan costs:
- Application fee: An upfront fee for processing your application, whether the lender approves you for the loan or not.
- Annual fee: A flat annual payment a lender charges each year your loan has a balance.
- Origination fee: A one-time fee to cover the administrative costs associated with processing and finalizing your loan.
- Penalty fees: A fee for late or missed loan payments. Some lenders also charge prepayment penalties if you pay off your loan early.
- SBA 7(a) guarantee fee: If you've borrowed money from a U.S. Small Business Administration (SBA) lender, you may pay an additional annual percentage-based fee depending on your loan amount and term.
The yearly total cost of your loan, which includes your annual interest rate plus any of the above fees that may apply, is expressed as your annual percentage rate (APR).
As you explore different business loans from different lenders, it's helpful to calculate your total costs to compare your options.
Factors that affect the cost of a business loan
The following factors can impact the overall cost of your business loan:
- Loan size and term: Since interest rates are calculated based on the principal loan amount, your interest payments will be larger if you borrow more money. You’ll also pay more in interest over time if you have a longer loan term.
- Interest rate: Lower interest rates mean lower overall payments. Your credit score is a primary factor here, but business lenders also consider how long you've been in business, how risky your industry is, and whether you take out a secured loan backed by collateral.
- Interest type: Interest rates can either be simple or compound. Many business loans come with a compound interest rate, which means you're paying interest on the interest that accumulated since your last loan payment (more on this below).
- Fixed vs. variable APR: APRs can either be fixed, meaning the interest rate and any other annual fees stay the same each year, or variable, meaning the interest rate (and therefore your interest payments) can fluctuate at the lender’s discretion.
- The lender's fee schedule and policies: Not every lender charges application fees, prepayment penalties, or other additional loan costs. For this reason, it’s important to choose your lender carefully and read the fine print to understand what you'll be responsible for as a borrower.
[Read more: 6 Documents to Prepare for a Small Business Loan Application]
How to calculate and compare the cost of a business loan
As you explore different business loans from different lenders, it's helpful to calculate your total costs to compare your options. Your total business loan costs depend on the interest rate and type (simple or compound) and any upfront or ongoing fees your lender charges.
These variables are used in most loan cost calculations:
- P = Principal loan amount
- r = Annual interest rate
- t = Loan term in years
- n = Number of times interest is compounded each year (typically 12 if making monthly payments)
- A = Your total loan cost
Simple interest calculation
A simple interest calculation only involves three straightforward factors:
P x r x t = simple interest
For example, if you borrowed $10,000 at an annual interest rate of 10% over five years, your total interest payment would be 10% of $10,000 ($1,000) times the five-year term.
$10,000 x 0.10 x 5 = $5,000
If your lender only charges you a one-time origination fee of 5% ($10,000 x 0.05 = $500) and you add that to the interest and A, or your total loan cost, the total would be $15,500.
Compound interest calculation
As mentioned above, compound interest is more common than simple interest and applies to most business loans. In short, it means you're paying interest on your principal loan balance plus your previously accumulated interest.
The formula for calculating the total loan costs with compound interest is
P (1 + r/n)nt = A
With the same $10,000 loan example listed above, here is the total you'd pay on that loan over its five-year term, minus any additional fees:
$10,000 (1 + 0.1/12)60 = $16,453.09
[Read more: How Is Interest Charged on a Small Business Loan?]
Business loan calculators
There are many helpful loan calculators available online to give you a rough estimate of your monthly payments. Here are a few you can try out:
Keep in mind that most online calculators do not account for any additional lender fees, so you’ll need to speak with a lender directly to calculate the true estimated cost of your loan payments.
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