Organizing your finances will help you to grow your business, so it’s key to have accurate information on your loan payments to succeed and aim higher. The loan payment that you make on your fixed-rate loans, lines of credit, credit cards, and other types of debt is really made of two components: the principal, which is the amount of money that goes toward paying down the amount you borrowed, and the interest, which is the amount of money that goes toward the fees accruing on the principal.
You pay these both at once in a single payment, so you might wonder why it’s important to keep track of your principal and interest; however, it’s important from a tax perspective as well as for business efficiency and planning purposes. Let’s take a deeper dive into how you can track the principal and interest on your debt.
Compounding is how often the interest on your loan is calculated. Every time interest is compounded, the lender determines how much more interest has accrued. The lender will determine your interest based upon your current outstanding principal balance as well as all interest that has accrued on top of that. The frequency that your loan is compounded can change how big your payments are and how much interest you pay overtime.
Most loans are compounded monthly, and recently, many online lenders use daily compounding. The more frequently a loan is compounded, the more interest you will pay in a year.
See the table below for an example of 12 months of interest on a $100,000 loan at 8% interest rate with no payments being made toward it:
How your payments are calculated
The payments that you make toward your debts are calculated in two different ways depending on the structure of your loan:
Term loans are set up so that you receive the loan funds when you get approved for the loan, and then, you pay off the loan in regular, gradual increments. For these loans, interest is usually compounded regularly and the payment that your lender selected is based upon two pieces of information: the term and the amortization.
The term is the actual length of time you will have to pay off the loan, usually expressed in months. The amortization is the length of time used to calculate your payments. Why aren’t these two numbers the same?
Sometimes lenders make the amortization of a loan longer than the term of the loan. This makes the payment is smaller than what it would be if the loan had to be paid off entirely in the term. The idea is that at the end of the term the remaining balance will be refinanced into a new lower interest debt or paid off. This is sometimes referred to as a balloon payment.
Lines of Credit:
With a line of credit, you can borrow whatever amount you need up to the approval limit. You’ll then pay interest on the amount of credit they used and will be subject to a minimum monthly payment when you have an outstanding balance.
When the line of credit is used, the loan is compounded in a similar way to a term loan. Lines of credit often have a clean-up period and must be paid off in full at least once a year for a certain number of days. This prevents you from using the line of credit for something that is more suitable for a term loan. Credit cards have a similar payment structure to lines of credit.
Recordkeeping for debt
Loans are often poorly tracked transactions in a small business’s bookkeeping system. That’s because loan transactions involve both the income statement, also known as profit and loss statement, and the balance sheet, and many small business owners are unfamiliar with these documents.
Additionally, the fact that loan payments are withdrawn from a business’s account in a single transaction that isn’t split into principal and interest makes the recordkeeping require outside information. The best practice of recordkeeping for debt involves two steps:
Step 1: Entering a new loan into the books
When your business takes out a new term loan, the deposit of those funds into your bank account is a transaction that happens entirely on your balance sheet. In simple terms, your cash increases by the loan amount in terms of assets, and the balance of your long-term debt grows by the same amount in the liabilities section. In accounting terms, cash in your bank accounts is debited and your long-term debt is credited.
Step 2: Record payments toward your loans
Each month when you receive a bill from your lender, use the bill itself as a guide for how much of the payment will go toward principal and interest. For each payment, record a split transaction with one transaction for principal recorded as a payment toward the loan balance in long-term debt, and the other transaction for interest recorded as interest expense on your profit and loss statement.
For loans with daily payments such as online loans, you should enter all the daily transactions as an interest expense. Then at the end of each month, you should login to your lender’s platform to see the real current balance on the loan and make an adjusting entry into your bookkeeping system to reclassify a portion of the payments toward principal.
For loans with fixed repayment amounts, such as merchant cash advances, the situation can be less clear. For instance, let’s say you have a loan of $100,000 with a fixed repayment amount of $120,000. Record the loan amount as directed above in step 1. Then, you can use step 2 to determine a split for each payment based upon how quickly you plan to pay it off. For example, if you pay off the loan in 24 months, you would take the difference between the repayment amount ($120,000) and loan amount ($100,000), which is $20,000, and divide it out evenly over 24 months.
On the whole, having accurate information on loans and their payments can lead to a better understanding of your business’s relationship with debt. You will be able to better understand the following: whether you’re paying too much or a fair amount of money for your debt and have the ability to refinance into a lower cost credit facility; you’ll have a better calculation of your tax liabilities; and you’ll know how much money is truly going toward operating and growing your business as compared to paying off your liabilities.