Yesterday, we had a prospective Friends and Family backer ask why, if he was lending $10,000 at 10% for one year, why he would only earn a $550 return.
The short answer is "amortization," one of the most important concepts in understanding how interest payments work.
What is amortization?
In lending terms, amortization is the process of reducing the amount owed as payments are made, usually on a fixed schedule (called an "amortization schedule"). Put simply, it means paying down the principal as you go.
Business owners need to understand amortization because it has a huge impact on the way interest is computed. Specifically, interest is only computed on outstanding (i.e., un-amortized) principal.
So, for instance, say you have a $10,000 small business loan with a 10% interest rate a 12-month term where you make payments monthly and interest is compounded monthly.
Assuming fixed payments, in month 1, you'll pay $879.10, of which $83.33 is allocated to interest (10% times $10,000 divided by 12) and the remainder to principal, bringing the outstanding principal to $9,204.23. In month 2, you'll still pay $879.10, but only $76.70 is interest (10% times $9,204.23 divided by 12). In month 3, only $70.02 is interest... and so on.
At the end of 12 months, you'll have paid down the principal completely, and paid $550 in interest.
But really, so what?
So what does that mean for you practically? Well, two things.
First, it means that assuming your loan is fully amortizing over its term, you'll actually pay less than interest than you think. A lot of business owners think that 10% interest means they'll pay 10% per year. But that's only true if you're making interest-only payments. If you're paying down principal, you'll pay less... a lot less on shorter term debt.
Second, it means that assuming your loan is fully amortizing over its term, your dollar amount paid is not the same as your interest rate. For instance, a lot of business owners assume that if they borrow $10,000 and have to repay $1,000 over one year, that their interest rate is 10%.
If the loan is fully amortizing, that's not true. For instance, if you're paying monthly, your true interest rate is 17.972%. If you're paying weekly, your true interest rate is 19.03%. And so on.
A lot of lenders will use this fact to confuse business owners in an attempt to make them think their interest rate is lower than it really is. That's why we recommend using a true-rate calculator to see how much you're really paying.