Small Business Taxes & Management^TM--Copyright 2024, A/N Group, Inc.

Introduction

The correct way to calculate the interest and the monthly payment on a term loan with constant payments is either use an app (on your computer or on your phone) or a financial calculator. But there is a shortcut that comes close to the actual amount--close enough to get a good idea of what the loan payments will be within 5 percent of the actual amount. First, here's a discussion on loans.  

Types of Loans

If you get a car loan or home mortgage the loan will almost assuredly be one with level payments and declining interest payments. The monthly payments for the term of the loan are equal. The loan is sometimes referred to as level debt service. Thus, as each payment is made the original principal decreases and the interest decreases because the interest is computed on a lesser amount of principal. For example, on a $100,000, 30-year loan at 7% your monthly payments would be $665.30. The first month of the loan the interest would be $583.30 and the principal paid off only $82. But that $82 reduces your total principal amount to $99,918.00 resulting in interest of $582.82 and principal of $82.48 the second month. Not a huge difference, but the loan is going down. By the 358th month interest is down to $11.34 for the month and principal is $653.96. In the 29th year your total interest is only 811.10. To find the amounts for a $500,000 loan simply multiply by five. That's why paying off a loan early with only a couple of years to go should be considered carefully.

If you take out a home equity loan, it's more likely to be level principal repayment. That's exactly what it means. The principal repayments are more likely to be equal so it's called level principal repayment. The interest is recalculated monthly and depends on the current interest rate and the principal outstanding. These loans are also used for commercial properties and other types of business loans.

Another common type of loan is a "bullet" loan, interest only, standing loan, or balloon loan. It's exactly what it sounds like. There are no principal payments during the term, only interest. At the end of the term the full amount of the principal is due. It can be used for a bridge or short-term loan such as a construction loan or for commercial properties.

There are other variations on these loans including irregular debt service and irregular principal payments and combinations of all of these. For example, an interest only loan for 5 years that turns into a level principal repayment.  

The Matching Theory

It's not talked much in the literature these days, but years ago finance professionals suggested matching the loan to the asset purchased or need. For example, if you're buying real estate you generally don't want to take out a short-term loan such as 3 years. Real estate is generally a long-term investment and the loan should be longer-term. Ten years is a good starting point, but you may go longer. The only reason for a short-term loan is if you expect interest rates to fall. Keep in mind that most commercial loans have a more costly and longer prepayment penalty than real estate loans for individuals.

On the other hand you don't want to take out a six-year loan to finance trucks that may only last four years. Talk to a financial advisor or banker who deals with businesses. Interest only loans can also be dangerous for short-lived assets since the asset will be wasted yet you'll still owe the full amount borrowed..  

Quickie Formula

Keep in mind that the only truly accurate gauge of the interest or payment amount on a loan is a financial calculator or app, either online or on your phone or computer. The advantage of the formula is that it's easy and quick. If you're not math oriented the most you'll need is a simple calculator. The formula is good for short- to medium-term loans, no more than 10 years. The accuracy drops off with the term of the loan. On a 30-year loan the payments will be off (too low) by 20$. That's too much for almost all purposes. At 10 years it's off by only 5%; again actual is higher.

The formula is easy:

TI = (i x P x L)/2

Where:

TI = total interest
i = interest rate
P = Principal borrowed
L = Length of loan in years

Example--You're offered $5,000, 5-year loan at 10% interest. Substituting

TI = (.1 x 5,000 x 5)/2 or $1,250

The first part of the formula computes the interest as if the full amount of the loan is outstanding for five years. But the principal is paid down every year so only about half is outstanding over that time period.

To compute the monthly payment simply add the total interest ($1,250) to the principal ($5,000) and divide by the number of months, 60 in this case. The result is $62.50. The actual amount is $66.07. That's close enough to decide if going further makes sense.

--Last Update 09/19/24