Financing is an essential aspect of business operations. Small businesses often take out loans for short-term expenses, working capital, payroll, or business investments, especially when cash flow is temporarily down. However, it can be challenging to know how to calculate the costs of business financing, such as a short-term loan to a long-term loan or a line of credit, because various lenders can express their costs differently, making it difficult for one to make an apples-to-apples comparison.
This article teaches you how to calculate the cost of business financing and the important terms associated with loan financing.
Summary
Important Terms to Understand
Below are the key concepts that will enable you to calculate the true cost of your business financing and also compare loans:
Loan Amortization
Loan amortization refers to paying off a debt over time through regular payments. Each payment consists of principal (the amount borrowed) and interest (the cost of borrowing the money). The term ” amortization” refers to the gradual reduction of the loan balance over time as the payments are made until the loan is paid off completely.
In an amortized loan, you will calculate the amount of each payment using a formula that factor in the principal amount, the interest rate, and the loan term. The formula ensures that the loan is paid off in full by the end of the term and that the borrower pays the same amount each period.
At the beginning of the loan term, most of each payment goes toward paying off the interest, with only a small portion to offset the principal. As you gradually pay down the loan over time, the amount that goes toward interest decreases while the proportion that goes toward the principal increases.
Amortization is a typical method of paying off long-term loans, such as mortgages or car loans, and is often used in personal and business finance.
Annualized Percentage Rate (APR)
Annualized Percentage Rate (APR) is the interest rate that is charged on a loan or credit card balance annually, including any fees or charges associated with the loan or credit. APR compares the costs of different loans or credit products and gives borrowers an idea of the true cost of borrowing money.
For example, if you borrow $1,000 for one year at a 10% APR, you would pay $100 in interest charges ($1,000 x 10%). The APR is usually higher than the nominal interest rate advertised by lenders because it accounts for all the costs associated with the loan, including any fees or charges. Comparing APRs when shopping for loans or credit products will allow you to get the best deal.
Total Cost of Capital (TCC)
Total Cost of Capital (TCC) is a financial metric that measures the total cost of all sources of capital used by a company to fund its operations and investments. It includes debt and equity capital and reflects the overall cost of financing the company’s activities.
You can calculate TCC by considering the cost of debt, the cost of equity, and the proportion of each in the company’scompany’s financial structure. The cost of debt is typically calculated based on the interest rate paid on the business’sbusiness’s outstanding debt. In contrast, the cost of equity is calculated based on the return investors require to hold shares in the company.
Monthly Payment
Monthly payment refers to the amount of money a borrower must pay to a lender every month to repay a loan. This payment typically includes both the principal amount of the loan and the interest charges accrued on the outstanding balance.
The monthly payment amount is determined based on several factors, such as the loan amount, interest rate, loan term, and any fees or charges associated with the loan. You can calculate the payment amount using a loan payment calculator or a formula that considers the loan’s interest rate and the repayment period.
It’s important to note that monthly loan payments can vary based on the type of loan and the lender’s terms and conditions. Before agreeing to a loan, you should review the loan agreement carefully and understand the terms and repayment schedule.
Interest
Interest is the cost of borrowing money. It is typically a percentage of the amount borrowed and is calculated over a certain period, such as monthly or yearly. There are different types of interest, including simple and compound interest. Simple interest is calculated only on the principal amount of the loan, while compound interest is calculated on both the principal and the accumulated interest. Compound interest is generally more common in loans and can result in higher interest payments over time.
Interest rates can vary depending on many factors, such as the borrower’sborrower’s credit score, the loan term, and the current market conditions. Lenders may also charge additional fees or charges that are added to the interest, which can increase the overall cost of borrowing.
It’s essential you carefully consider the interest rate and terms of any loan or credit agreement before making a decision.
Understanding the interest rate and associated fees can help you make informed decisions about borrowing and repayment strategies.
The Formula for Calculating the Cost of Business Financing
The formula for calculating a business loan’s cost depends on the loan’s type and terms. However, the most common formula for calculating the cost of a loan is the annual percentage rate (APR) formula.
The APR formula considers the loan’s interest rate, any additional fees or charges associated with the loan, and the repayment term. Below is the APR formula:
APR = (2 x N x I) / (P x (N+1))
Where:
N = the number of payments over the life of the loan, I = the interest rate per payment period, P = the principal (or amount borrowed)
You can use the formula to calculate the cost of most types of loans, including term loans, lines of credit, and merchant cash advances. However, it’s important to note that some lenders may use different formulas or methods to calculate the cost of their loans.
Need Assistance with Business Financing?
No smart business owner wants a shortage of capital. Successful entrepreneurs ensure they have a consistent cash flow to cater to their needs and grow their companies. However, securing financing for your small business can be challenging when your only available option is traditional banks. This is because banks emphasis much on credit score and history, collateral, and personal guarantee. Plus, there is a lengthy application process and much paperwork if they finally decide to consider your request.
At Financing Solutions, we provide an easy-to-set-up (it takes less than two minutes to fill out) business line of credit for small businesses to take care of unsteady cash flow. Our small business financing product requires no collateral or documentation to get a written offer letter. Numerous other alternative lenders have a rigorous application process and can be relatively expensive.
The founders of Financing Solutions have started and grown many businesses together, so we understand how essential it is to keep costs low. That’s why we don’t charge you anything to set up the credit line, and there are no maintenance fees or hidden charges. We don’t ask for personal guarantees, and you can receive a non-obligation offer letter the same day. The approval decisions are based on our decade of experience working with small businesses.
Find out today why we have five-star ratings from the Better Business Bureau and Google. And if you want to see if your small business would be approved and for how much, please fill out the no-obligation, 2-minute line of credit application here.
