Understanding the Amortisation Schedule of Small Business Loans
Almost every small or medium-sized business needs to borrow at one time or another. Whatever the business sector, the experience is very much the same: the company will have to identify precisely what it needs, draw up a shortlist of potential lenders, implement ways to improve their chances of receiving lending, and agree the loan terms.
In all the excitement of obtaining the money to take the company to the next level, many business owners fail to focus on the last part of the equation which is paying back the loan and interest, and then discover that loan repayments significantly affect their cash flow. That’s why you need to draw up a small business loan amortisation schedule.
So what’s an amortisation schedule?
Put simply, this is a projection of how you will pay off your loan. Your amortisation schedule will set out each repayment in a clear, easy-to-understand format so you can see exactly what you will be paying and when, and what impact this will have on your finances. The schedule will also help you to compare different loans with different terms, which can otherwise be difficult. Get it right and different interest rates, fees and other variables will all become easy to understand, enabling you to make a more informed decision on where to get the best small business loan.
What terms do you need to know?
Before compiling your loan amortisation schedule (or better still, using an online calculator to do the heavy lifting for you), there are a number of terms with which you will need to familiarise yourself.
Capital (also known as Loan Amount): the amount you are borrowing, before factoring in any interest, fees or other costs.
Total repayment: the entire amount you will repay to your lender, comprising capital, interest and fees.
Loan period: the amount of time you will take to repay the capital. This is usually expressed in months.
Principal: the element of each repayment that goes to repaying your small business loan (i.e. the part that is not interest).
Interest: the element of each repayment that is not principal (i.e. that does not directly reduce the amount you owe).
Cumulative interest: the total amount of interest paid over the life of the loan.
Annual interest rate: the interest charged annually on a long-term loan, expressed as a percentage and including any arrangement fees.
Effective Annual Percentage Rate (APR): the actual percentage rate you will pay, factoring in arrangement fees and any other charges. This represents the truest cost of borrowing, which is why banks (though not all lenders) are required to disclose this figure upfront.
Opening balance: the amount you owe before payment is made within a given period.
Closing balance: the amount you owe after payment is made within a given period.
What types of amortisation schedule are there?
In general, your loan amortisation will depend on how quickly interest compounds on your small business loan, whether daily, weekly or monthly. Typically this will match the frequency of your repayments, though there are occasional exceptions. For this reason, it is important to clarify the loan’s compounding period, as well as the repayment schedule, in order to create meaningful data.
Monthly small business loan amortisation
For a traditional multi-year loan with monthly repayments, a monthly loan amortisation schedule is the way to calculate your repayments. With this type of loan, you will usually make the same payment month in and month out.
Daily loan amortisation
However, some short-term loans amortise daily. Take out this type of loan and you will make repayments on each working day.
Weekly loan amortisation
Whilst you may assume that loans with weekly repayments amortise weekly, this is very often not the case – many such loans amortise daily, so it is crucial to clarify this.
A brief overview of interest on small business loans
Simple versus compound
The same interest rate quoted by different lenders does not necessarily mean the same repayments – it all depends whether the interest is simple or compound. Simple interest means that if you borrow £50,000 at an interest rate of 10%, you repay £55,000.
However, most small business loans attract compound interest. This means that interest is calculated on both the amount you borrow and on accumulated interest. Interest can compound daily, weekly or monthly, usually matching the repayment schedule. In other words, the more frequent your payments, the more compound interest you will pay.
Annual interest rate versus factor rate
Typically, if you take out a multi-year business loan you will be quoted an annual interest rate. Whilst this provides a close approximation of what you will repay, it does not include arrangement fees or other costs (which are included in the effective interest rate).
However, some business lenders instead quote a factor rate. For instance, if you borrow £50,000 at a factor rate of 1.1 you will repay £55,000, just as in the example above. However, there’s one big difference: with a factor rate, paying early will not save you any interest as the £5,000 in lieu of interest is added to the loan upfront.
The most important figure – which will allow you to compare dissimilar loans – is the effective interest rate. The APR (Annual Percentage Rate) of any small business loan takes into account the principal, the term, the interest rate and any arrangement fees, and banks are required by law to disclose this figure upfront. However, the rules are different for alternative lenders.
How interest payments change over time
Whilst some loans offer a fixed monthly repayment of capital plus whatever interest has accrued, most specify a fixed payment that includes both capital and interest. With this type of loan, your early payments will be largely interest and some capital and later payments will be mostly capital and a little interest. This means that the loan will take longer to pay off, as the capital outstanding is initially reducing quite slowly.
What happens if you make additional payments?
Of course, if your business is doing better than expected, then you may not stick to your repayment schedule – you may be able to pay back the small business loan sooner than expected. This could save you a considerable amount of money, provided that the loan attracts an interest rate and was not charged using a factor rate.
Whether you make regular additional payments (let’s say, increasing your monthly repayment from £1,000 to £1,500), occasional extra payments when a large order comes in, or a lump sum to pay off what remains of the loan, this will significantly affect the amortisation schedule and must be factored in immediately.
It’s important to bear in mind that some loans apply a penalty if you repay early. With this type of loan, there is rarely much advantage to early repayments, unless you can very quickly pay off the entire capital. Similarly, there is point whatever in paying back a loan with a factor rate faster than agreed.
When do loan amortisation schedules not work?
Whilst an amortisation schedule is a good way of calculating what you will repay and when, it doesn’t work for every type of borrowing. With a merchant cash advance, you repay the capital plus interest and fees via an agreed percentage of your company’s daily credit card sales. This is a good solution for companies with wildly varying turnover, as you will never have to pay more than you can afford, but since the interest doesn’t amortise at a fixed rate it is impossible to prepare a repayment schedule or calculate the total interest.
Meanwhile, with invoice factoring and discounting you borrow against the value of your invoices as soon as you issue them, with repayment being made when your customers pay you. Typically, this type of finance is charged via a weekly interest rate and/or a monthly fee and there are no set repayments.
Finally, a business line of credit operates more like a credit card: you have an outstanding capital balance and are only required to pay the interest. At any point, you may repay any or all of the capital, with debt only beginning to amortise once you start paying off the principal. If you steadily repay the capital, then you can prepare an amortisation schedule, but in most cases borrowers will repay sporadically when taking out this type of credit so there are some situations that suit this form of credit best.
Preparing your loan amortisation schedule
In the bad old days, the only way to prepare a loan amortisation schedule was to sit down with pen, paper and a calculator and work it out manually. Then along came spreadsheet programs, which could perform the basic calculations – but you still needed to know all the formulae before attempting the task.
Nowadays, there are a number of online calculators that can perform the entire task, so there’s no need to blind you with science by discussing the actual calculations. For starters, we recommend using one of the following:
Whilst these calculators are fairly general, and don’t take into account all the specifics detailed above, they represent an excellent starting point. If your circumstances are more complicated, a Google search should bring up precisely the tool you need, as there are plenty of them out there.
A few things to bear in mind
When preparing your amortisation schedule, you need to bear a few key points in mind.
First, as we’ve already stated, not all loans amortise in the same way. In general, if a small business loan involves monthly repayments, the interest will amortise in the same way, but this isn’t always true (and, confusingly, loans with weekly repayments tend to amortise daily).
Similarly, the way interest is charged – whether you pay a fixed monthly sum including both interest and capital or a fixed amount of capital plus whatever interest is owed – will have a huge impact on your total repayment, particularly if the loan term is over quite a number of years. (However, it’s worth bearing in mind that with the latter approach, your first few payments will be quite substantial, so you may not be in a financial position to take out this kind of loan.)
Most importantly, whilst amortisation schedules help you compare the real costs of different kinds of loan, there are a number of circumstances in which they cannot be used – when you take out a merchant cash advance, invoice factoring or discounting, or a line of credit. That’s because these financial products have no structured repayments, so the total cost to you will depend on your evolving circumstances.
Getting the business finance you need
Finally, whilst a loan amortisation schedule will enable you to compare the real cost of diverse small business loans – and, equally significantly, project your repayments so that your cash flow does not become derailed – it is crucial to remember that the cheapest loan is not always the best.
If your business is seasonal or has a turnover that fluctuates hugely, fixed monthly repayments may not be the way to go. You could well find that a merchant cash advance – as expensive at it is – will give you extra flexibility and ensure you never encounter a payment you will struggle to make. Similarly, if you own a business-to-business company, invoice factoring and discounting can tame a troublesome cash flow for good, though this isn’t a viable means of borrowing for investment (since you can’t take out a long-term loan for a large sum).
It’s also worth noting that whilst overdrafts, lines of credit and business credit cards tend to attract very high rates of interest, they offer the ultimate in flexibility – all you need to pay is the interest, making them ideal if your company suddenly suffers a downturn.