How much should I pay back on my loan?

Someone contacted me recently with a question that I thought would be a good topic to cover here at Your Money and Your Business. The situation was that they had taken a loan out and wanted to pay it back, but they weren’t sure how much they could. So they came to me for my perspective.  Here’s the approach, and you can use it for not just making big loan payments, but for anything where you want to see how much you can afford to do with what you have available.

In short, I told them that 1) they should pay back as much as they could 2) while leaving enough money in their account to cover upcoming expenses (i.e., a reserve), and 3) that the amount they should keep in the bank could be higher or lower depending on whether or not they could get money lent back to them again.

So what does this mean? Well, let’s unpack it. The first point should be obvious: if we have money available to pay back on a loan that is costing us interest, then let’s pay it. So what is available?  It’s how much money you have beyond money you need to keep for upcoming expenses, which leads to our second point.  I might have $350,000 in the bank, but I need to figure out how much I need for upcoming expenses.

Well, I like to see clients keep enough money on hand to pay for expenses over the next one to three months. So if the annual budget is $1.2 million, then they should have $100,000 to $300,000 readily available, some of which could be in an interest-bearing account to make money for the company while being on standby. Therefore, any money that the business has above the reserve amount can be used to pay back the loan. Let’s put real numbers on it: say that the business owner is comfortable with two months of reserves (2 x $100,000 = $200,000) and has $350,000 in the bank. They could pay back $150,000 on the loan, leaving them with $200,000. So far this is fairly straightforward:

However, businesses often have to pay credit cards, sales taxes, and payroll taxes in the near term too. This reduces how much they have available. On the flip side, a lot of businesses invoice their clients on terms and are expecting payments from clients during this time. How do we account for money that hasn’t been received yet or paid out yet?

Well, we include these in how much need to have available. So it’s not $200,000 in cash, but $200,000 of net combined cash, accounts receivable, and liabilities. Let’s revisit this with real numbers again. Let’s say that the business 1) has $175,000 in cash, 2) has $125,000 in receivables, 3) owes $25,000 in payroll taxes and also 4) owes $15,000 in sales tax.   Here’s the calculation:

It makes sense, right? What I have plus what I expect, less what I owe, all give me what I have available, and if I have more than I need, I can use that to pay back the loan.

So this leads me to the third and final point: if this is a revolving credit line where it is easy to pull money back out, then you can be more aggressive about paying it down. Having the confidence knowing that you can get the money in an emergency helps. But if it’s a loan where draws can’t be taken out again, then caution is the word. It would be pretty miserable to pay a chunk of that loan down, only to find yourself in a jam in a couple of months and wishing you had that money back or that you had to go through the hoops of going back to the bank and applying for another loan.

That’s how we do the calculation and how you can to!

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