Understanding Interest-Only Business Loans in Four Steps
November 9, 2018 | Last Updated on: July 15, 2022
November 9, 2018 | Last Updated on: July 15, 2022
Interest rates are one of the most important aspects to consider when applying for a new loan. The rate that is attached to a loan can add thousands of dollars to the final payoff and can significantly increase the monthly payment amount youâ€™ll be responsible for. Individuals and businesses alike pay interest, which composes a large chunk of their monthly payments and overall amount due. So how do you make interest work in your businessâ€™s favor? One of the best ways is with an interest-only loan.
In many traditional loans, the interest rate is calculated, and the borrower makes monthly or regular payments, which is split between a principal amount (the original amount borrowed), an interest amount, and may include fees or other charges.
For the purposes of simplicity, weâ€™ll cover simple interest loans, where the interest amount is a flat fee that is included with normal payments. In many cases, the interest is front-loaded into the early payments of a loan term, which just means that the borrowerâ€™s payments for the first year (or years) are sent mostly to cover the interest.
This is fine for larger, long-term purchases like homes, commercial buildings, and investment properties, but can cause problems if the loan is used to purchase less long-lived items like vehicles or equipment. With the first payments covering interest only, the principal is left mostly untouched, leading to a situation where the purchased (and now used) item is worth less than the amount owed â€“ known as being â€śupside downâ€ť or â€śunder waterâ€ť.
In contrast, interest-only loans are exactly what they sound like: The borrower agrees to monthly payments and a term that requires them to pay only the interest charges for their loan. At the end of the agreed term, all of the interest charges will have been paid, but the principal amount still remains untouched. A large â€śballoonâ€ť payment must be made to cover the principal, or some other arrangement must be made to pay off the actual amount borrowed.
There are plenty of reasons why an interest-only loan may be appealing for a business to pursue, but just like any other financial decision for your business you have to pay careful attention to whatâ€™s really best-suited for your company.
When a traditional loan payment is made, the interest rate and principal are combined, along with any other fees that may be required. This can cause the total payment amount to end up being very large each month. While the payments are being applied to reduce the amount owed to principal, at least in part, business owners may want to find a way to avoid those higher payments and still be able to obtain the loan.
Interest-only loans typically have lower payments because the amount due each month is only used to cover the interest charges for the amount borrowed. Many business owners will make the decision to pursue an interest-only loan for this reason, because the monthly outlay is so much lower than what would be paid to interest and principal in a traditional loan.
They may also view this as a prudent financial decision, because their money can be placed into investments that generate better returns instead of being applied heavily against a loanâ€™s principal. Even though the full loan amount will be due at the end of the interest-only term, the borrower may have invested the money they would have paid to principal in their business and generated enough income to pay that amount in full.
Because the recurring payments are lower than traditional loans, interest-only loans may allow the borrower to afford a much larger loan total up front. If you donâ€™t have to make high payments every month to cover principal, you can afford to take on a slightly larger amount so that you can do more for your business with the cash. This is good for businesses that are starting out or growing their operations, especially if they have to invest in capital-intensive projects like buying new property or setting up manufacturing processes.
But the business owner has to be certain that their income will grow over time. If there are any interruptions in the businessâ€™s cash flow as the loan due date approaches, it may become incredibly difficult for the business to repay the original loan amount.
The overall interest amount may be higher for an interest-only loan due to the sometimes riskier nature of the loans compared to traditional products. In some cases, the lender will charge an interest rate that is higher than a traditional rate for an interest-only loan as a safety measure. Some lenders will also justify higher rates on the argument that the borrower can afford the larger interest payment on these loans since there is no principal repayment each month. Because the lender may view the interest-only loan as being riskier than a traditional loan, these rates are usually difficult to negotiate.
Adjustable-rate interest-only loans have their own set of challenges. Just like with a traditional adjustable-rate loan, the interest rate can grow over the course of the payment term, which means the borrower will end up having to cover a much larger amount than they originally planned. An adjustable-rate loan may be appealing to the business owner because the initial rate can sometimes be lower, but there must be a plan in place to cope with rates that may grow to be much larger than the initial amount.
Another important fact to note is that at times there may be a prepayment penalty for interest-only loans. These fees are charged when a borrower tries to settle their loan amount before the loan term timeframe has passed. Lenders charge these penalties to cover their risk, because a borrower that pays early or refinances before the term is complete will end up paying less overall interest. This can cut into a lenderâ€™s profit, so many add prepayment fees into the loan contract to cover that cost.
During the course of an interest-only loan term, the borrower isnâ€™t required to pay anything against their actual loan amount, also known as the principal. Since the loan has to be paid off regardless of the interest payments, this principal amount is required as a final, or â€śballoonâ€ť payment at the end of an interest-only loan term. As you can imagine, having to make a single payment to cover the entirety of a loan amount may be a hardship if the business hasnâ€™t been able to generate the additional cash flow that was expected when taking out the loan. So this is a situation that business owners must plan for when considering an interest-only loan.
In other cases, the principal amount may be refinanced or paid off over time, but there may be additional interest or fees applied to this balance. When this happens, the borrower is essentially paying interest twice on a loan instead of paying it off. This can obviously cost much more over time than a traditional loan or by following the original loan terms and satisfying the principal payment all at once.
As long as a borrower is able to plan accordingly and understands the risks, an interest-only loan can be a powerful tool in a businessâ€™ financial toolbox. They can allow low-cost investments in much larger assets than a traditional loan because of their lower payments. They may also help new or growing businesses gain access to larger loan amounts that they otherwise could not afford. Unlike traditional loans, however, there is considerable risk involved if the business isnâ€™t able to improve its performance during the time the loan is outstanding, so there is more planning required to ensure the total loan amount can be paid when it comes due. Like anything, an interest-only loan agreement should be studied thoroughly before signing, because prepayment penalties or other charges may turn a powerful financial tool into an expensive nightmare for business owners.