What it means
Every loan has four core terms: the principal, which is the amount borrowed; the interest rate, which is the price of using the money; the term, which is how long you have to repay; and the security, which is what the lender can claim if you do not. Change any one of these and the cost and risk of the loan changes with it.
Loans matter because they let a business buy an asset that will earn money over years without paying for it all in one go. The test is simple: if the return generated by what you buy exceeds the interest cost, borrowing adds value, and if it does not, borrowing destroys it.
Most business loans are amortising, meaning each payment covers the interest accrued plus a slice of the principal, so the balance falls steadily to zero. Others are interest-only with a bullet repayment at the end, which keeps monthly cash outflow low but leaves a large sum to find or refinance at maturity.
Interest rates come as fixed or variable. A fixed rate gives certainty for budgeting, while a variable rate moves with a benchmark and can rise sharply, which is why lenders often stress-test affordability at a rate several points above the current one.
Fees deserve as much attention as the headline rate. Arrangement fees, valuation costs, legal charges and early-repayment penalties can add a meaningful amount to the true cost, which is why comparing loans on the annual percentage rate is more honest than comparing quoted interest rates.
The nuance most borrowers underestimate is the covenant package. Beyond repayment, agreements typically require minimum ratios, limits on further borrowing and regular reporting, and breaching one of these can make the whole balance repayable immediately even if every payment has been made on time.
In practice
Real-world examples.
Example
A dental practice borrows $180,000 over seven years to fit out a second surgery. The new surgery generates $95,000 of additional annual profit before financing, comfortably covering the loan payments and leaving room if rates rise.
Example
A haulage firm takes a five-year loan secured on six new trucks. Because the lender holds security over the vehicles, the rate is 3 points lower than the unsecured alternative the firm was offered.
Example
A cafe owner borrows $40,000 on an interest-only basis for two years to survive a slow period. When the bullet repayment falls due, trading has not recovered enough and the owner has to refinance at a higher rate. The low payments during the interest-only period had made the borrowing feel cheaper than it was.
Formula
Calculation
For an amortising loan, Monthly payment = P x r / (1 - (1 + r) to the power of -n), where P is the principal, r is the monthly interest rate and n is the number of months. Take a $250,000 equipment loan at 8% a year over 5 years, so r = 0.08 / 12 = 0.006667 and n = 60. The monthly payment works out at $5,069.10. Over 60 months the borrower pays $5,069.10 x 60 = $304,146.00, of which $304,146.00 - $250,000 = $54,146.00 is interest. In the first month, interest is $250,000 x 0.006667 = $1,666.67 and principal repaid is $5,069.10 - $1,666.67 = $3,402.43, so the balance falls to $246,597.57.Case study
Seen in the real world.
Crestwood Joinery is an invented business used purely as an illustrative example of loan decision-making. It needed a $250,000 computer-controlled cutting machine that would save $9,000 a month in outsourced work.
Rather than pay cash and empty its reserves, the illustrative company borrowed the full $250,000 over five years at 8%, giving monthly payments of $5,069.10. Because the monthly saving of $9,000 exceeded the payment by $3,930.90, the machine funded itself from month one and the business kept its cash buffer intact.
Crestwood's one difficulty came from a covenant requiring its current ratio to stay above 1.3. A large stock build before Christmas pushed the ratio to 1.24 for one month, and although the bank granted a waiver, the finance team began forecasting covenant positions quarterly rather than reacting after the event.
Watch out
Common mistakes.
- Comparing loans on the monthly payment alone, when a longer term lowers the payment while raising the total interest paid.
- Ignoring arrangement fees, valuation costs and early-repayment charges, which can add several percent to the true cost of borrowing.
- Assuming that keeping up payments is enough, when a covenant breach can make the entire balance repayable on demand.
Questions
People also ask.
What is the difference between secured and unsecured lending?
A secured loan gives the lender a claim over specific assets if you default, which usually means a lower interest rate and a larger available sum.
Is a fixed rate always safer than a variable rate?
Not always, since fixed rates are usually priced higher at the outset and often carry penalties if you repay early or want to switch.
Should a profitable business borrow at all?
It can be sensible when the return on the funded asset exceeds the after-tax interest cost, since that spread adds to owner returns.
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