Basic Debt Terminology Every Business Owner Should Understand

Building your business, expanding your services, buying machinery, and everything else, requires access to capital.

Debt is one of the easiest ways to access this much-needed capital.

But before you walk into the bank and bet on yourself, ask yourself if you understand the proper terminologies of debt and how it works.

You can only assess if it is the right decision for you or your business if you properly understand what you hear when your loan officer talks about debt.

We are going to make it as simple as possible so that you aren't just sitting in a chair nodding back at them. So here goes... Read and re-read as many times as you need.

Basic Debt Terminology

Premium

The premium is the amount of money you borrow, not including the interest you promised to pay back. Premium can also refer to the balance you still owe after you pay off some of what you borrowed already.

Let's say you borrowed $15,000 at 4.9% interest. After two years, you paid down $5,000. Now you owe $10,000.
The $15,000 and $10,000 are premiums at different points in time.

Interest Rate

The interest rate on debt is the cost of your debt. It is the amount of money in addition to the premium you promised to pay back.

A percentage is the most common way to see interest expressed. ie. 4.9% in the example above.

Remember, wherever you make a monthly payment, a portion of your payment goes toward paying off the interest while the remainder pays off the premium.

As your premium gets smaller, so does the interest you are paying.

There are two types of Interest Rates:
Fixed Rates
These are rates that never change during the entire lifetime of the loan.

Variable Rates
These are rates that can change at different points of the loan term.

Collateral

Collateral is something considered to have economic value. It is a way to secure the loan so the lender can feel protected and get back his money if you can't make your payments.

Types of Debt

There are many different types of debts. Ensure you understand two of the most basic, as you will likely cross paths with them when dealing with financial institutions.

Secured Debt

Secured debt is a debt used to purchase something that in most cases will be used as the collateral for that debt. An easy example is taking out a loan to buy a house. You use the house as collateral. Then, if you cannot make the payments for the loan, the lender can repossess it to get back their money.

Unsecured Debt

Unsecured debt is a debt that doesn't have collateral to protect the lender. An easy example of this is a credit card. You can access one without any collateral. You gain access to financing without having to put anything upfront.

The downside with unsecured debt is that it usually comes at a higher interest rate to protect the lender. An unsecured debt has a higher risk than a secured debt and is thus the reason for a higher interest rate.

Loan Term

The loan term is the agreed-upon timeline in which you will repay the loan. For example, if you accessed a loan and agreed to repay it within 60 months, the loan term would be 60 months.

Amortization Schedule

The amortization schedule is the set schedule by which you will pay down a loan. It includes any interest, taxes, and fees over the loan term. It is usually in fixed installments.

For example, if you have a loan of $15,000 for 5 years, at 4.9%, you would make 60 monthly payments of approximately $283.

Every time you make a payment, you need to calculate the interest and pay that first. Then you use the remainder to pay off the premium of your loan.

Every month, the premium reduces resulting in smaller interest payments over time. The amortization schedule helps you to understand how this differs from month to month.

The Challenge

This week, ask yourself if you understood these terms and analyze if you are ready to sit across from a loan officer and access that capital you now need.

And remember to leave us a comment to let us know if you found it helpful, or would like more help with knowledge about debt. We are always happy to hear your feedback.