##### Small Business Loans

## How do Loans Work?

Even if you don’t get a loan with us at CIC, it’s still important to understand how debt works. How do interest rates work? What is APR? What does “amortization” mean? If you’re planning to use debt as a form of financing—in your business or even in your personal life—we hope this page will help.

### Basic Loan Calculator

If you go no further down on this page, at least make use of our Loan Calculator. This particular calculator assumes you are accruing interest and making payments on a monthly basis. In addition, it gives you the monthly payment necessary to entirely pay off your debt by the end. Most loans work this way, but not all, so keep reading to learn more.

Enter Loan Data: | |
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Amount of the loan ($): | |

Annual interest (%): | |

Repayment period (years): | |

Additional Fees ($): |

Payment Information: | |
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Monthly payment: | $ |

Number of payments: | |

Total interest: | $ |

Total cost of loan: | $ |

### Advanced Loan Calculator

For more advanced calculations, we have put together an Excel file. With this calculator, you can see your entire payment schedule mapped out in a table.

Please click this link, and then **DOWNLOAD** the file. (The web version is read-only.)

### Term Loans

A term loan is a loan for a specific amount of money that’s paid back on a schedule over a specific period of time. The amount of time given for payback is referred to as the term. Interest may or may not be charged, but typically is. This is the most common type of loan, though there are other ways to borrow money, such as through a credit card, line of credit, or merchant cash advance, to name a few.

### How Interest Works

Interest Explained

In most situations, when you take out a loan you will be charged an interest fee on a periodic basis. This is what you are paying the lender for the privilege of using their money.

Typically, interest is charged as a rate, or percentage, of the amount of money being borrowed. Interest can accrue, or build up, on a daily, monthly, annual, or other basis.

Interest rates are typically advertised and quoted on an

*annual*basis. However, if interest is accruing on a different basis, it’s important to convert the rate. If it’s accruing monthly, for example, you’d take the annual rate and divide by 12, since there are 12 months in a year. (Conversely, to convert an interest rate from monthly to annual, you’d multiply by 12.)Calculating Interest Payments

Monthly accruing interest is common, so let’s use an example:

*Danny takes out a loan of $10,000. The annual interest rate is 12%, but interest accrues monthly. How much interest will accrue each month? To figure this out, take the following steps:*

*Convert annual interest rate to monthly rate: 12% ÷ 12 = 1%**Multiply loan balance by monthly accrual rate: $10,000 x 1% =***$100**of interest each month.

There are various arrangements borrowers can make with lenders not only about the interest rate, but also how often interest accrues, how often payments need to be made, etc.

In order to understand some of the most common types of loan arrangements, you will need to understand a few more terms, so please read on.

### What is Amortization?

Amortization Explained

Amortization is a scary sounding word, but it’s necessary to understand if you want to get a loan without getting ripped off. Fortunately, it’s easier to understand than it is to pronounce!

Each time you make a payment on a loan, you’re generally responsible for paying off any accrued interest. If there’s money left over after that, it goes towards the principal—the amount still owed from the loan initially taken out.

By paying extra towards the principal, you are

*amortizing*your debt, or slowly killing it off. Indeed, the word “amortization” comes from the Latin*admortire*, or “to kill.”Examples of Amortization

*Unamortized Loan*

If your payment structure on a loan is such that you are only paying interest, it’s said to be “unamortized.” This is because your payments are only covering interest; they aren’t “killing off” the principal debt at all.

*Fully Amortized Loan*

If your payment structure is such that your regular payments will entirely pay off the debt (both interest and principal) by the end of the term, it’s said to be “fully amortized.”

*Partially Amortized Loan*

There’s also something in between, sometimes referred to as a “partially amortized loan.” For a fuller explanation of this, see the Common Loan Examples section below.

### Common Loan Examples

Constant Payment, Fully-Amortized Term Loan

Let’s imagine that Brian takes out a loan of $8,000 to buy a car. He agrees to a 9% annual interest rate and to pay off his debt by making monthly payments for a 12-month term.

While 9% is the

*annual*interest rate, the lender informs Brian that the interest will accrue (build up)*monthly*. Therefore, we will use his monthly interest rate, which is 9% ÷ 12 =**0.75%**.Each month then, Brian must pay an additional charge of 0.75% of his remaining balance.

After the first month, Brian will owe $8,000 x 0.75% =

**$60**in interest.Let’s say Brian makes a payment of $700. The first $60 will go toward the accrued interest and the remaining $640 will go toward the

*principal**—*the amount he still owes from what he initially borrowed.After the second month, Brian’s new principal balance is $8,000 – $640 =

**$7,360**. Thus, his interest charge will be $7,360 x 0.75% =**$55.20**.In a “Constant Payment” loan, Brian will again make a payment of $700. This time around, however, a little bit more of that payment will go towards the principal, because he owed less in interest.

Each month, Brian’s interest payment will decrease, meaning more of his $700 will go towards paying back the loan. As it turns out, with 12 payments of $700, he will entirely pay off his debt. He will have paid back $8,000, plus around $400 in interest.

We chose this example because it happens to have pretty round numbers. However, in most loan arrangements like this, while the loan amount and interest rate may be easy round numbers, the monthly payment will be something complicated and harder to calculate. If you are interested in the math, check out Khan Academy’s class on loan payment calculation.

Interest-Only Loan (Unamortized) Term Loan

Let’s imagine Caroline takes out a loan of $50,000 for her bicycle shop. She agrees to a 6% annual interest rate. While the loan needs to be paid off entirely within 3 years, she is only required to pay the interest each month.

The interest rate is 6%

*annual*, but the interest accrues on a monthly basis. Therefore, we will use her monthly interest rate, which is 6% ÷ 12 = 0.5%.After the first month, Caroline will owe $50,000 x 0.5% =

**$250**in interest.Each month for 3 years, Caroline will pay $250. This adds up to 36 payments x $250 =

**$9,000**. At the end of 3 years, Caroline will still have to pay back the loan itself ($50,000), and will owe what’s called a*balloon payment*. In total then, Caroline will have paid $59,000.Caroline may decide she wants to start paying down her loan earlier in the process. Let’s imagine that halfway through her loan (18 months), Caroline makes a payment of $20,000 towards the principal (the amount she still owes).

For the remainder of her loan, her monthly interest payments will now be based off her new principal balance: $30,000 x 0.5% =

**$150**. At the end of her loan, she will have paid 18 payments @ $250 + 18 payments @ $150 = $4,500 + $2,700 =**$7,200**. In addition to the principal payment of $20,000, she’ll make a balloon payment of $30,000 at the end. In total, she will have paid $57,200.The benefits of paying down her principal early are two-fold: 1. she pays less in interest overall, and 2. her balloon payment at the end will be smaller. Assuming there is no pre-payment penalty, it’s a smart move!

Partially-Amortized Term Loan

Nick would like a loan for $50,000 for his food truck business. His lender wants to charge 10% annual interest and for it to be fully paid back via monthly installments over a term of 5 years. If this loan were a fully-amortized, constant payment loan, the monthly payment would come out to almost $900/month. (Use our Loan Calculator above to see for yourself.)

Nick knows he can’t afford this payment and asks for a 10-year loan, since the monthly payment will only be $482. His lender understands his situation, but is also resistant to extending a loan out 10 years—the food truck business can be volatile, and his truck, business, etc. may not be worth much 10 years from now. It’s a risk for them.

Fortunately, they are able to reach a compromise.

The loan will be amortized over 10 years, which means Nick will keep the lower payment of $482/month. At this rate, it will take 10 years for the loan to fully pay off (or amortize). However, the

*term*on the loan itself is still 5 years. This means that at the 5-year mark, the entirety of the remaining loan is due. He will have to make a large balloon payment.This is what’s sometimes referred to as a “partially-amortized loan.”

As long Nick understands what’s happening, it can be a good arrangement. During the first five years, he has sufficient cash flow to build his business up and increase profitability, in hopes of making his balloon payment at the end. If he can’t afford to pay it off entirely at the 5-year mark, he may be able to get another loan to pay off the first one (referred to as “refinancing”) and then continue making payments till he’s out of debt.

The danger to this type of loan is when the borrower thinks they’ll be paid off at the end and doesn’t realize they have a balloon payment. In addition, the size of the balloon may be larger than expected. In this example, you might expect Nick’s balloon to be $25,000 since he’s halfway through the amortization period, but it’s actually about $31,100. (It’s higher because during the early period paying back a loan, most of the payments are going towards interest, rather than principal.)

### What Affects My Ability To Get A Loan?

Before spending time applying for a loan, it’s helpful to know what factors affect your likelihood of approval. Below is a list of pros and cons.

Some lenders have looser requirements but if you are deemed a risky borrower, they will likely charge you more interest.

Pros

- Your business is profitable, currently and historically.
- If you are breaking even, you can show how the use of a loan will immediately make you profitable.
- You have assets, which can be used as collateral.
- You (or the owners) have good personal credit.
- You have outside income.
- You can share business financials (e.g. a Profit & Loss Statement and Balance Sheet).

Cons

- The reverse of everything in the “Pros” list.
- You are an early stage business/startup and don’t expect to be profitable any time soon.
- You have no personal investment in your business.
- Your business doesn’t pay taxes or shows a loss on its taxes.

### Be a Savvy Borrower

There are many steps where you can get tripped up during the loan process. Whether you get a loan from us at CIC or with someone else, we want you to be educated. Check out our tips below to be a savvy borrower.

Tips Before Getting A Loan

- Verify whether your interest rate is annual or monthly.
- Ask for any other fees (in addition to interest).
- Ask for the “total finance charges.” This the total cost of the loan, which includes both interest AND any fees charged by the lender, third parties, etc.
- Ask whether there’s a “balloon payment.”
- Use our advanced loan calculator or search for an “amortization calculator” online to understand your cost, APR, etc.
- Ask whether they will require collateral.
- Ask whether you need to sign a personal guarantee.
- Ask what happens if you miss a payment.
- Ask if there are pre-payment penalties and if so, how they work.
- Ask your lender to show you the loan documents ahead of time. Read them, ask questions, and/or review them with your lender.
- Verify that anything promised to you is contained in your loan docs. Remember, the loan docs trump any verbal agreement you may have made.

### WHAT TYPE OF LOAN IS FOR ME?

If you are interested in applying for financing, please fill out our inquiry / pre-application form. This will help us learn more about which product offerings might apply to you, and will ensure you don’t waste your time by filling out the wrong application.

##### For more information

### If you are not ready to apply but would like to discuss the possibility of a loan or have questions, we are here to help!

Contact us at lending@cictucson.org or **520-529-1766 x206**.