small business loans

how do loans work?

Loans may be structured several different ways but the two most important aspects to consider are the interest rate (type and method) and the repayment schedule for the loan.

There are two options to set your interest rate:

• Fixed Rate: With a fixed rate the interest rate (i.e. the percentage) applied to the outstanding principal remains constant through out a predetermined period that may or may not equal the length of your loan. The interest rate is set at the beginning of your loan by examining the risk involved and the current market rates. The advantage of a fixed rate loan is that your interest rate is fixed and the payments constant and they will not rise if the market rate rises. The disadvantage is that you will not benefit from a decline of the market rate.
  
  
• Variable Interest Rate: With a variable interest rate the interest rate applied on the outstanding principal amount fluctuates in line with changes to the Bank Base Rate or LIBOR and, as a result, so will the amount of your payments. The interest rate for each period will be the current market rate plus a predetermined premium that remains constant throughout the life of your loan. The advantage of a variable interest rate loan is that you save money when the market rate decreases. The disadvantage is that you are not protected from an increase in the market rate and the interest you pay will increase with the market rate.

When deciding on your repayment schedule you should always remember the longer you take to payback the principal the higher your total interest payment will become:

• "Equal" Payments: This type of loan requires you to pay the same amount each period (monthly or quarterly) for a specified number of periods. Part of each payment goes toward interest and the rest goes toward principal. After the specified number of periods you will have paid back the entire loan plus all interest.
  
  
• "Equal" Payment and a Final Balloon Payment: This type of loan requires you to make equal monthly payments of principal and interest for a relatively short period of time. After you make the last instalment payment, you must pay the balance in one payment, called a balloon payment. Some lenders will give you the option to refinance the loan to help you stretch out the final balloon payment. This type of loan offers definite benefits to you. Because of the lower monthly payments during the course of the loan, you can keep more cash available for other needs. Of course, when you are thinking about those nice low payments, don't forget the big balloon payment waiting around the corner.
  
  
• Interest-Only Payments and a Final Balloon Payment: With this type of loan, your regular payments cover only interest. The principal stays the same. At the end of the loan term, you must make a balloon payment to cover the entire principal and any remaining interest. The obvious advantages of this arrangement are the low periodic payments. But over the long term, you will pay more interest because you are borrowing the principal for a longer time.
  
  
• Single Payment of Principal and Interest: If your lender agrees, you can promise to pay off the loan all at once at a specified date. This payment includes the entire principal amount and the accrued interest. Borrowing money on these terms is best for a short-term loan.
  
  
• Equal Principal Payments: This type of loan requires you to pay the same amount of principal each period for a specified number of periods. The total payment for each period will be variable (and should decline) as you pay interest only on the outstanding principal at the beginning of the period. Borrowing money on these terms requires larger payments in the beginning of the loan.