08/06/2021
THE BANK AND YOU
Loans and Loan Repayment
When you approach the bank for a loan for your business, they will primarily be interested in your ability to repay and they will therefore consider a number of variables, including whether or not you have collateral, your history with the bank and your credit rating.
When you receive the loan, your monthly repayments will depend on three things:
1. The amount you borrow;
2. The repayment period; and
3. The interest rate.
(The interest rate applied to your loan may be either fixed or variable.)
For the purpose of this mini-tutorial, we will assume that the interest rate is fixed over the term of the loan.
Your loan will be amortized, ie a schedule of periodic payments will be computed which will allow for the loan principal and interest cost to be fully paid off in the agreed period.
Each scheduled payment will consist of an amount that goes towards reducing the principal and an amount that goes towards paying the interest cost.
In the early part of the loan period, a larger proportion of the payment goes toward interest cost and this proportion is reduced over the term of the loan.
Let us take an example:
Amount of loan: $500,000
Repayment period: 3 years
Interest rate: 14.5%
The loan is scheduled to be repaid in 36 fixed monthly payments of $17,210.49 each.
In the first month, $6,041.67 goes toward payment of interest while $11,168.82 goes to reducing the principal, ie the amount that you borrowed.
By the end of the first year, the portion of the payment that goes toward interest is $4,464.12 while $12,746.37 goes to reduce the principal.
By the 36th and final month, the payment of $17,210.49 is apportioned as follows:
Interest cost: $205.48
Repayment of Principal: $17,005.01
At this point, the loan is fully paid off.
Total interest cost of this loan, or the cost of borrowing $500,000, is $119,577.59.
*Important things to note:
Based upon the experiences of our clients we advise that, when applying for a loan, you:
1. Ensure that you know the interest rate that will be applied;
2. Ensure that you receive a copy of the loan agreement.
3. Ensure you receive a printout of the loan repayment schedule.
This will allow you to know, at any point in time, how much of the loan principal is still outstanding.
4. Try to schedule your loan repayments over the shortest period of time to minimize total interest cost.
For instance, in the example above, the interest cost of borrowing $500,000 at 14.5% interest and repaying over 3 years is $119,577.59.
If the same amount is repaid over a period of 5 years the interest cost would be $205,848.
A final word - Refinancing a loan:
As a result of the Covid-19 pandemic, many persons, especially small business owners, have had to refinance their loans to spread them over a longer period and thereby reduce their monthly payments. As mentioned above, one consequence of this is that the total interest cost increases significantly.
However, another consequence which many persons are unaware of, is that when a loan is refinanced, a new amortization schedule is computed. As we showed, in the earlier repayment period of a loan, more of the monthly payment goes toward interest and this gradually tapers off.
If you refinance after a year or two, the proportion of your payment that goes toward interest will again start at the highest amount and you will have 'foregone' some of those higher payments toward interest that you made in the early period of the original loan.
Do let us know if you found this information useful and feel free to email us with your questions at [email protected]
