You wouldn’t get money from a bank, throw it in the river, and say that’s how your cash floats. Neither would you leave to chance what a bank or lender charges for your business loan, credit card, or MCA. Knowing how to calculate interest rates on these financial products is crucial for small businesses.
That’s where we come in. Our job in this post is to explain how to calculate interest rates and the importance of using that knowledge. Then, when it’s time to crunch numbers, you can figure how much your business can afford.
Interest Rates 101
What are simple interest rates?
If you don’t know how interest rates work, they probably seem like a complicated thing. However, simple interest rates are not that complicated if you understand them. They are quick and easy to calculate, and the calculation requires basic information.
Simple interest rates are not only used to calculate loans but to determine the amount of interest you can earn when depositing money into a savings account, certificate of deposit, and other interest-bearing instruments.
What about compound interest?
On the other hand, compound interest takes into consideration both principal and accumulated interest when calculating the interest you continue to earn monthly/annually.
To better illustrate compound interest, envision throwing a snowball downhill. Your snowball is your principal. As it goes downhill, interests start adding to the principal, and then this mix of interest and principal attracts even more interests. It grows and grows.
In other words, you accumulate interest on past interests.
With simple interest, you wouldn’t create interest on past interest, only on the principal. So it’d be like getting a second snowball for interests that never grows.
Why it’s essential to know the interest rates
Entrepreneurs use interest rates to make calculations about future profits.
When interest rates are low, it’s a better time to borrow money to expand a business. Consequently, interest rates help entrepreneurs determine the best time to launch a product or service. An interest rate adjustment in either direction means borrowers could save or spend a significant amount of money.
A business credit card at a 5% interest rate is a bargain compared to having one that charges 25%. Those savings add up very quickly and allow business owners to invest strategically in their businesses. Another way to build wealth is to lower the high-interest rates on your existing loans.
Furthermore, it makes good business sense to make deposits into a savings account earning 5% compared to 0.05%. Add those savings to taking out a loan at 5% versus 10%, and you’re well on your way to building a retirement nest egg or emergency fund.
You want your return on investment to be as high as possible to give business profits an uptick.
How to calculate interest rates
Here are easy-to-use formulas to calculate interest rates on these types of business credit:
For a business loan, interest is accrued daily against the principal loan balance. For example, if you borrow $10,000 and your Annual Interest Rate is 10%, you will accrue a daily interest of $2.78 until there is a decrease in your loan’s principal balance.
But how did we arrive at this number?
Here are a few ways to calculate the periodic interest on your business loan:
Daily Interest Rate = (Annual Interest Rate in decimals / 360 days ) x (Principal Balance)
Monthly Interest Rate = Daily Interest x 30 days
These formulas consider months with 30 days and years with 360 days (30 x 12). Most banks and lenders use these numbers. Why? Because it’s easier to make calculations if all months are the same.
How much interest will I pay for the 1st month?
Using these formulas, and the example of a $10,000 loan with an Annual Interest Rate of 10%, we can calculate your first month’s accrued interest:
First change your Annual interest rate to decimals by dividing it by 100 (10% / 100 = 0.10)
Daily Interest Rate = (0.10 / 360) x $10,000
Daily Interest Rate = 0.0002778% x $10,000
Daily Interest Rate = $2.78
Then, we use the daily rate to calculate the monthly rate:
Monthly Interest Rate = $2.78 x 30 = $83.40
How much interest will I pay for the following months?
Great question, with a loan, you won’t pay the same each month, your interest varies.
Let’s assume you borrowed the $10,000 for 12 months at the same Annual Interest Rate as above (10%). Your lender will use a PMT equation to calculate equal monthly installments for your loan. This will result in a monthly payment of $879.16 ($795.76 + your first monthly interest rate of $83.40).
Use our business loan calculator to know your monthly loan installments.
After you make your first installment of $879.16, your principal balance will also decrease, meaning your second month’s daily interest will change. The reason why it will reduce is that your monthly installment is made up of interest and principal attributes.
Your principal balance would now be $9,204.24 because you already paid $795.76 (the $83.40 interest will not be subtracted from the principal). Now let’s calculate your 2nd month’s interest:
Daily Interest = (0.10 / 360) x $9,204.24 = $2.56
Monthly Interest = $2.75 x 30 = $76.80
As you can see, with every new payment, your monthly interest changes.
If you continue to calculate until you reach 12 months, you can derive the total interest charged on your loan and can determine the Annual Percentage Rate (“APR”).
To determine the interest you pay on your credit card balance each month, divide your annual percentage rate by 360 days.
Daily periodic rate = APR / 360 days
If your credit card charges a 15% APR, your daily interest rate is 0.041% (15% / 360).
Each bank calculates interest rates in different ways, so to calculate your interest rate, you’d need to know what type of method they use. Most banks use one of the following two methods:
Daily Balance Method
Interest Rate (Daily Balance Method) = Balance x Daily periodic rate / 100
The thing is, you need to make this multiplication for every day in your billing cycle. Imagine your balance is $2000, and your daily periodic rate is 0.041%.
Interest rate = $2000 x 0.041% / 100 = $0.82
So, for the first day in your billing cycle, you owe $0.82 in interest. Add that to your balance of $200 and calculate again for the second day.
Interest rate = $2000.82 x 0.041% / 100 = $0.82
And again for the third day…
Interest rate = $2001.64 x 0.041% / 100 = $0.82
And you keep repeating it until the 30-day billing cycle ends. If you repeat this process at the end of the period, you’ll owe $2,024.75 (a total of $24.75 in interest).
This is how compound interests work: interests are calculated on interests.
Average daily balance
Interest Rate (Average daily balance method) = Average daily balance x daily rate x 30 days / 100
(To calculate your average daily balance, you need to add up the daily balance of the 30 days of the cycle and then divide by 30)
Imagine your average daily balance is $300, and your daily periodic rate is 0.041%.
Interest rate = $300 x 0.041% x 30 / 100 = $3.69
At the end of the billing cycle, you owe $3.69 in interest.
MCA (Merchant Cash Advance)
Merchant cash advances don’t work with interest rates; they work with factor rates. These are not shown as a percentage but as a multiplier. Factor rates are not affected by time (you’ll pay the same for your MCA if you repay in 1 month or six months). This means you won’t be able to save money if you make early payments.
Lenders assign a factor rate when advancing cash to a business. Let’s say they quote a factor rate of 1.4 on a $30,000 MCA repaid in 12 months. To know how much you’ll end up paying, you need to multiply the cash advance amount by the factor rate.
Total of your MCA = principal x factor rate
Using the data from the example, you’d end up with this formula: $30,000 x 1.4 = $42,000. That means that for an MCA of $30,000, you’d pay an interest of $12,000.
On the other hand, if you know how much you’ll end up paying but you don’t know what your factor rate is, you can find it with this formula.
Factor Rate = (total of your MCA) / principal
In the previous example, you’d divide the total of your MCA ($42,000) between the principal ($30,000), and you’d arrive at your factor rate of 1.4.
MCA’s factor rates tend to range between 1.1 and 1.5. The lower your factor rate, the cheaper your MCA will be.
While factor rate and interest are not the same, it’s important to compare them. For example, a factor rate of 1.4 could be compared to an interest rate of 40%. That is a huge amount! That’s why MCAs are considered a very expensive financial product.
Knowing how to calculate interest rates puts you in control
Running a business doesn’t mean everything always goes according to plan. But being the boss does mean you can have more questions than answers. But what’s truly important is that you search for those answers, because that will help you grow and become more successful.
That’s why knowing how to calculate interest rates is to your advantage and relieves some of the pressure of owning a business.
At Camino Financial, we make lending easier for our members. We use a straightforward approach, whether you need to apply for one of our small business loans or a microloan. After getting pre-approved, we match you with the best loan for your business, and funding can occur in days, not weeks.
When working with us, you’ll readily see that our motto, “No Business Left Behind,” is the driving force behind everything we do. We encourage you to apply for a loan today and see for yourself how we are different from other lenders.
Until then, here’s another helpful article: