How Business Loans Work: Payments, Coverage, and the Fine Print

The parts of a loan

The principal is the amount you borrow. The interest rate is the yearly price of borrowing it. The term is how long you have to repay. And the amortization schedule decides how each payment splits between interest and principal over that term.

Most small business term loans are fully amortizing: equal monthly payments that bring the balance to zero on the last one. Some aren't. A loan with a balloon leaves a large chunk of principal due at the end, which keeps monthly payments low and makes the final payment a refinancing problem you have to solve before it arrives.

Where each payment goes

Take a $100,000 loan at 8% a year for five years. The monthly payment works out to about $2,028.

In the first month, interest is 8% ÷ 12 of the full $100,000, or $667. The other $1,361 reduces the balance. Each month the balance is a little smaller, so the interest share shrinks and more of the same payment goes to principal. By the final year almost every dollar is paying down the debt. That schedule is amortization.

Over the five years you pay about $121,700 in total, so the loan costs roughly $21,700 in interest. A longer term lowers the monthly payment and raises that total. Stretching the same loan to ten years cuts the payment to about $1,213 and more than doubles the interest, to about $45,600.

Fixed or variable

A fixed rate stays the same for the life of the loan, so the payment never changes. A variable rate moves with a benchmark, often the prime rate, plus a margin the lender adds. Variable loans usually start cheaper, and the risk that rates rise sits with you.

The size of that risk is easy to estimate. On a $100,000 variable balance, a three-point rise in rates adds about $3,000 a year of interest at the start. Ask whether the business could absorb that before choosing the cheaper-looking option.

What the lender checks before saying yes

Lenders care most about whether the business can make the payments out of its own cash flow. The standard test is debt service coverage: the cash the business generates for paying debt, divided by the year's loan payments.

The $100,000 loan above costs about $24,300 a year. If the business produces $36,000 a year that could go toward debt, coverage is about 1.5. Lenders set a minimum, commonly around 1.25, so the loan still gets paid in a year when earnings dip.

They also look at collateral: assets they can claim if the loan isn't repaid, such as equipment, property or receivables. And for most small businesses they ask for a personal guarantee, which lets them pursue the owner's personal assets if the business can't pay. Read that clause carefully, because it turns a business debt into your own.

Covenants: the rules that come with the money

A covenant is a promise in the loan agreement about how the business will operate while the debt is outstanding. Some require keeping a ratio above a floor, such as coverage above 1.25. Some forbid things without the lender's permission, like taking on more debt or selling major assets. Most require regular financial statements.

Breaking a covenant can put the loan in default even if every payment arrived on time, and default can let the lender demand the full balance. Know your covenants, track them every quarter, and talk to the lender early if you're heading toward one. Lenders have far more flexibility before a breach than after it.

Match the loan to the thing it pays for

A long-lived asset, such as a vehicle, a machine or a building, fits a term loan whose length is no longer than the asset's useful life, so the debt is gone before the asset is. Swings in working capital, like buying inventory before a busy season, fit a line of credit that you draw down and repay as cash comes back.

Mismatches cause trouble in both directions. Financing a truck on a credit card means paying card rates for years. Covering payroll with a ten-year loan means still paying for last spring's wages in 2035.

In the US, many small business loans carry a partial guarantee from the Small Business Administration. An SBA loan is made by a bank; the government guarantee reduces the bank's risk, which can make it willing to lend on longer terms than it otherwise would.

Key takeaways

• An amortizing loan's payments start mostly interest and end mostly principal; a longer term lowers the payment and raises the total interest.
• Variable rates usually start lower and move the risk of rising rates onto you. Estimate that cost before choosing one.
• Lenders test debt service coverage (cash available for debt ÷ annual payments), commonly wanting a cushion around 1.25.
• Personal guarantees and covenants matter as much as the rate: one makes the debt yours, the other can trigger default without a missed payment.

Frequently asked questions

What credit score or revenue do I need for a business loan?

It varies by lender and loan type. Banks look at the business's cash flow and coverage, its time in operation, collateral, and the owner's personal credit, especially when a personal guarantee is involved. Newer businesses often have more luck with smaller loans, equipment financing, or government-backed programs.

Is interest on a business loan tax-deductible?

In many tax systems, including the US, interest on money borrowed for business purposes is generally deductible as a business expense, subject to limits and rules that change over time. Repayments of principal are not deductible. Check the current rules with a tax professional.

What happens if I breach a loan covenant?

The lender can usually treat it as a default, which may allow it to raise the interest rate, charge fees, or demand repayment. In practice lenders often agree to a waiver or amendment, especially when the borrower raises the issue early and has a plan.