June 26th 2023.
Amortized loans are a popular form of financing for medium- and long-term needs, usually over 3 years. The amount you pay stays the same throughout the term, but the allocation of that payment changes with each installment. Interest is paid first, with the remainder going toward the principal. The first payment will have the highest percentage applied to the interest and the lowest to the principal.
As the balance decreases, the interest declines, and more of each payment goes to the principal loan amount. For example, say you borrowed $250,000 at an 8.5% interest rate for a 5-year term. Your monthly payment would be $5,129.13, and over the loan term, you’d pay $57,748 in interest. The first month’s payment would have $1,771 applied to the interest and the remaining $3,358 to the principal.
In contrast, simple interest loans are easier to calculate and often used for short-term financing. The principal and interest are split equally into fixed payments, and the interest does not change over time. Factor rates are often used to express simple interest, ranging from 1.05 to 1.5 or higher. The annual interest is multiplied by the interest rate and then divided by the 12 months in a year.
When deciding which loan type is best for you, consider the terms, rates, prepayment options, collateral requirements, approval criteria, and funding times. Amortized loans have lower effective APRs and longer terms, but more total interest will be paid. They also require collateral and take longer to fund. Simple interest loans have higher APRs and shorter terms, but are unsecured and usually fund within 1-3 business days.
Amortized loans are a popular choice for businesses that need medium-term and long-term financing. With an amortized loan, you have a fixed payment and interest rate for the duration of the loan, but the amount applied to the principal and interest changes with each payment. The first payment will have the highest percentage applied to the interest and the lowest percentage applied to the principal amount. As the balance decreases, the percentage of the payment that goes to interest decreases and more goes to the principal.
For example, say you borrowed $250,000 at an interest rate of 8.5% for a five-year term. Your monthly payment would be $5,129.13 and you would pay $57,748 in interest over the loan. The first month’s payment would have $1,771 applied to the interest owed and $3,358 applied to the principal.
Simple interest loans are much simpler to calculate. These loans are usually used for short-term financing solutions, and the principal and interest payments are divided equally with no changes over time. Interest rates are often expressed as factor rates, which range from 1.05 to 1.5, or as a percentage. Unlike an amortized loan, the amount of interest owed does not fluctuate with each payment.
It's important to consider the differences between the two loan types when determining the best small business loan structure. An amortized loan is typically for medium- to long-term loans, while simple interest usually applies to much shorter funding arrangements. Amortized loans usually have lower annual percentage rates, but you pay more total interest in the long term. Simple interest loans have higher APRs, but you usually pay less total interest.
When it comes to prepayment, amortizing loans allow you to reduce your total interest by paying down the principal or paying off the loan early. Simple interest loans do not allow for prepayment since the interest is applied at the beginning of the loan and then divided over the payment schedule.
Most amortized loans require collateral, while simple interest loans are usually unsecured. Approval requirements also differ between the two loan types. Amortized loans usually require a business to have at least 1-2 years of operation and good personal and business credit. Simple interest loans are usually more flexible and some lenders will approve businesses with only 4-6 months of operation and lenient credit score requirements.
When it comes to funding times, the underwriting process for amortized loans is more time intensive, so it takes longer to close and fund the loan. Simple interest loan underwriting requirements are more flexible and funders can usually approve and fund these loans within 1-3 business days.
When deciding between an amortized loan and a simple interest loan, there are many factors to consider. Understanding these differences can help you choose the best loan structure for your business.
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