Key takeaways: 

• Loan term significantly impacts monthly payments and total cost, often more than just the interest rate. 
  
• While a lower interest rate is beneficial, evaluating the full loan package, including the loan term, is crucial for financial planning. 
• A shorter loan term generally leads to higher monthly payments but a substantially lower overall cost of the loan due to reduced total interest. 
• A longer term generally results in lower monthly payments, which can help business cash flow. 
• Comparing different loan scenarios based on both interest rate and loan term is essential to minimize total loan cost and manage cash flow effectively. 

When it comes to your loan payments, you might think it's all about getting the lowest interest rate, but that's only part of the story. While your loan rate is undoubtedly important, your loan term often may have a far more substantial and immediate impact on your monthly payments. Today, we're diving deeper to explain why you need to consider the entire loan package, not just the rate. 

What is the difference between the loan rate and the loan term? 

A loan term is how long you have to pay back the money you borrowed – usually discussed in terms of months or years. Think of it as the period you'll be making regular payments. For instance, a 30-year loan means you'll have thirty years to pay it off.  

The loan interest rate is the price you pay to borrow money; shown as a percentage of the amount you're borrowing. A lower rate means you'll pay less in interest over the entire term of the loan. For example, a 9% rate will save you money each year compared to a 12% rate for the same loan period. 

Principal is another handy term to know when reading this article. Principal refers to the amount of money borrowed from a bank, before interest or fees are added.  

And finally, let's define cash flow. Cash flow is the money your business has coming in versus going out each month. 

How do interest rates and loan terms affect my monthly loan payments? 

So, how do both the loan rate and loan term affect how much you pay each month? Here's where it gets interesting, and where many people make a common mistake. Everyone tries to find the lowest interest rate possible, which is smart, but they often forget to think about how the loan term (how many years you'll be paying it off) changes both your monthly payments and the total amount you'll end up paying back. 

Let’s look at an example. Imagine you're borrowing $1,000,000 from a bank to buy a business. With a 25-year term and a 9.5% interest rate, your estimated monthly payment is $8,736.97. The total cost of the loan will be $2,621,089.98, including principal and interest. But, if you shorten the term to 15 years, even with the same 9.5% rate, your estimated monthly payment jumps significantly to around $10,442.25! The total cost of the loan, including principal and interest, would be $1,879,604.43. 

The shorter term increases the monthly payment by $1,705.28 per month. 

Now that we've illustrated the impact of loan terms, let's look at a more common scenario for comparing loans. Let's say you need $350,000 for working capital for your business and approach two lenders for a loan.  

Lender A offers you a $350,000 loan with a 10-year term and a 10% interest rate. That would be a monthly payment of $4,625.28. 

Lender B offers you $350,000 with a 2-year term at 5% interest rate. That would be a monthly payment of $15,354.99. 

You can see that, even though your interest rate from Lender B is half that of Lender A, your monthly payment is over three times higher with Lender B. This example reiterates the point that rate is important, but if you're just rate shopping and your loan isn't structured correctly, the short-term stress to your business could be costly.  

The faster you pay off the loan, the less the money costs in the long run. However, if you pay back the loan over a shorter period, you're cramming all those principal and interest payments into fewer months. That means each payment will be bigger. Larger payments directly impact your monthly cash flow. Your business needs to have good cash flow so you can cover bills, pay your team and save money for a rainy day or an opportunity. Strong cash flow ensures you'll be ready for whatever comes your way, whether good or bad.

The impact that rate has on your total cost of funds

It's important to remember that although a shorter loan term means you'll pay more each month, you'll typically end up paying much less in total interest by the time the loan is paid off. Think about our $1,000,000 example: that 15-year loan, even with its higher monthly payment, would save you a lot of money in interest compared to the 25-year loan, even if the interest rate was the same. Why? Because you're paying down the principal amount of the loan much faster, which means less interest builds up over time. The reality is that while it's ideal to have a lower total cost of funds, most businesses benefit from the extra monthly cash flow with a longer loan term. It depends on your business’s unique needs and goals. 

Don't forget to read the fine print on your loan  

While the concept of loan terms and interest rates is pretty simple, the reality is that comparing loan options can be highly complex. This is why it's essential to work with a reputable lender who will guide you through the options with transparency and clarity. For example, you might see an interest rate of 1%, which sounds great, right? However, if you don't read the fine print, it might be too late before you realize that the rate is 1% per day! It may sound ridiculous, but it happens.  

Tip: Predatory lenders are operating in the market. We have a whole blog post about it, make sure to check that out and protect yourself and your business.   

How do you pick the right loan for your business?

How should you approach choosing a loan package? The key takeaway is this: Don't just get fixated on the loan rate. The loan term is equally important when it comes to your financial planning. It also helps to work with a lender that understands your business and can guide you to the loan package that meets your unique needs. 

When you're shopping for a loan, look at the entire package and how these factors combine to determine your monthly payment and the total amount you'll repay. Finding the right balance that fits your budget, and your financial goals is key. 

FAQs  

Q: How are loan payments calculated? 

A: In simple terms loan payments are calculated by taking the total cost of the loan (principal plus interest) and spreading it out over the loan term. However, this is a rough estimate. Interest is charged on the outstanding principal balance, which decreases over time as you make payments. Your lender will be able to give you an accurate monthly payment. 

Q: What factors influence my loan interest rate? 

A: Your credit score, the current economic conditions (like the prime rate set by central banks), the type of loan (secured vs. unsecured), the loan term, and the lender's policies all influence the interest rate you're offered. 

Q: What is an APR (Annual Percentage Rate) and how does it differ from the interest rate?  

A: Annual Percentage Rate (APR) factors in the interest rate and all the different costs and fees associated with a loan over a year. The interest rate is just the cost of borrowing the principal amount, without those extra fees. APR provides a more comprehensive view of the loan's true cost. 

Q: How does my credit score affect the loan terms I can get?   

A: A higher credit score generally indicates lower risk to lenders. This potentially may translate to more favorable loan terms, including lower interest rates and potentially more flexible repayment options. A lower credit score, conversely, may lead to higher interest rates and stricter terms.