When considering a loan for your franchise business, the size of the monthly payment will be determined by both the length of the term and interest rate. To ensure that you can comfortably pay back your loan on a monthly basis, it's important to understand how these factors are interrelated and find the best combination for your needs.
How term affects payment size
The term, or amount of time you're afforded to pay back your loan, directly impacts the size of your monthly payments. While a lower interest rate may minimize the money you spend paying back your loan overall, it's vital to consider how high monthly payments may inhibit cash flow and interfere with business operations.
For instance, imagine there are two borrowers, both taking out loans for $400,000 at an interest rate of 8%. One borrower selects a loan product with a 7-year term length. The other opts for a loan with a 10-year term length. Extrapolated across three franchise unit locations, the first borrower will need to make monthly payments totalling $18,703. The second borrower will owe $14,559 on a monthly basis.
Loan Amount (3 locations)
Interest Rate
Loan Term (yrs)
Monthly Payments
$1,200,000
8%
7
$18,703
$1,200,000
8%
10
$14,559
The second borrower pays thousands of dollars less each month, allowing him to maintain more liquidity and potentially priming his business to expand with new units at a faster rate.
How interest rates affect payment size
Now let's look at the same scenario, this time examining the impact of interest rate on the monthly payment while holding the loan term constant. One borrower has an interest rate of 8% and the other has a rate of 9%.
Loan Amount (3 locations)
Interest Rate
Loan Term (yrs)
Monthly Payments
$1,200,000
8%
7
$18,703
$1,200,000
9%
7
$19,306
The change in rate translates to only a $603 difference (3%) in monthly payment size as compared to the impact of $4,144 (22%) in the example above. In short, interest rate is far less impactful on monthly payments than term length.
Interest rates play a smaller role in monthly payment sizes than you may realize.
"Borrowing money at the lowest interest rate possible always seems best on the surface, but you need to be aware of how the loan as a whole will affect you," says Ryan Muskar, a franchise finance specialist at ApplePie Capital. "Low interest rates are great, but if you have to put up your home as collateral, or agree to certain loan covenants, it will impact your personal finances and potentially prevent you from expanding in the future."
Compare terms and rates strategically
When weighing your options regarding term lengths and interest rates, it's vital to understand how each loan product will impact the health of your franchise business. Paying more money in the long term may make more sense than opting for a loan with a lower interest rate but shorter term length.
"It's something we come across often," Ryan says. "We get phone calls from people who took out a loan with too short of a loan term. They have a very low interest rate, but their monthly payment is thousands more than they can afford. And refinancing is not as easy as people think it is. Your franchise business has to be viable in order to refinance. Most lenders have credit policies that have to be met and a majority of them are not willing to be a bail-out lender."
It's much easier to get the right loan in the beginning than it is to fix it after the fact. Keep that in mind when comparing how loan terms and interest rates affect your payment size, and by extension, your franchise business stability.
