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How to Calculate Your Short-Term Loan Interest
Interest is money down the drain. For a loan to be worth it, you must be able to earn more from what you invest your loan in than the total interest you pay.
Fundvisor aims to keep you informed about business borrowing, so we’ve created this quick guide to calculating your loan interest.
Types of Short-Term Loans
You have several choices for short-term loans. Picking the best might be a struggle. Fundvisor can help you understand each of the following options in detail so you can see if any are right for your business.
- Installment loan: Regular loans can be short-term.
- Invoice financing: You can put up your accounts receivable as collateral for a loan.
- Merchant cash advance: A mix of a loan and a cash advance. You borrow against your future credit sales.
- Line of credit: A revolving amount of credit you can dip into when need be. Repayment terms are typically one month.
Factors That Affect Total Short-Term Loan Interest
Lenders charge interest to earn profits, but also to hedge against risk. Higher interest dissuades many borrowers with bad credit. When uncreditworthy borrowers take out a loan, the larger interest payments ensure the lender makes extra cash, should the borrower fail to pay back the loan.
With that in mind, here are the primary factors influencing your interest costs.
- Interest rate: The most obvious factor. A higher interest rate results in more interest over the life of a loan, all other things held equal.
- Loan amount: A 5% rate on a $10,000 loan will result in more total interest than a 5% rate on a $5,000 loan.
- Term length: A longer loan term results in higher interest costs. Paying 5% interest on a 10-year loan will result in more payments of the same amount than on a 5-year loan, meaning more total interest.
- Repayment amount: Since the loan amount affects your interest, you can reduce your overall interest costs by paying above your minimum. You’ll pay off the loan faster and deal with less interest.
- Repayment schedule: Payment frequency also matters. Making extra payments means a fast payoff time — which leads to less interest.
It’s also worth noting that longer loan terms and larger loan amounts tend to come with higher interest rates. Longer or larger loans are riskier to the borrower.
Simple Interest
Some lenders charge simple interest on short-term loans.
Simple interest is a breeze to calculate. The formula is as follows:
Principal x Interest Rate x Term Length = Total Interest
For example, if you have a $10,000 loan at 5% interest with a 5-year repayment term, your total interest would be $2,500.
Amortization
The opposite of simple interest is compound interest, a process where the interest you incur is tacked on to the principal.
Compound interest is more complex and often more expensive than simple interest. When you add more to the loan balance, you incur more interest next time.
The formula is as follows:
P[1+(r/n)]^nt = A
A = final loan balance
P = initial loan balance
r = interest rate
n = amount of times interest is added to principal each period
t = number of time periods
So for a 5-year, $10,000 loan with a 5% interest rate compounded monthly, you’d pay a total of $12,833.59. That means you paid $2,833.59 in interest.
No need to calculate this by hand, though. You can use a compound interest calculator to find out your total interest costs.
Most lenders use an amortization schedule anyways and factor in compounding.
Amortization means you pay the same amount every month, with earlier payments weighted more towards interest. Only a small portion goes towards principal.
However, as the amount of remaining principal decreases, you’ll be charged the same interest rate on a smaller dollar amount — yet pay the same amount of dollars each month.
As a result, more of your payment covers the principal balance.
Interest compounds in an amortization schedule, but the lender determines your monthly payment ahead of time, so you may pay less interest than if you didn’t amortize.
Fundvisor is here to help if you aren’t sure which short-term financing source is right for you. We’ll deal with the paperwork and phone calls for you so you can get the funding you need without wasting valuable time.
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