How Interest Is Calculated on Business Loans

Simple interest versus compound interest

Simple interest applies the rate to the original principal only. If a company borrows £100,000 at an annual simple rate of 8%, the interest charge for a full year is £8,000 regardless of whether any capital has been repaid. Compound interest, by contrast, applies the rate to the outstanding balance including any previously accrued interest that has not yet been paid. For short-term business facilities the practical difference is modest; over multi-year terms it can be significant.

Most conventional term loans in the UK commercial market use a reducing-balance method, which sits between the two: interest is charged on the outstanding principal at each calculation date, so the interest element of each instalment falls as capital is repaid. Revolving credit facilities and some bridging products use daily simple accrual against the drawn balance, settled at the end of each month or drawdown period.

How daily accrual works in practice

Under daily accrual, the annual rate is divided by the day-count convention — typically 365 in UK commercial lending, though some lenders use 360 — to produce a daily rate. That daily rate is multiplied by the outstanding balance each day, and the resulting charges accumulate until the next settlement date. A £200,000 facility at an annual rate of 9% accrues approximately £49.32 per day under a 365-day convention (illustrative, not a quote).

The day-count convention matters because a 360-day divisor produces a slightly higher effective daily charge than a 365-day divisor for the same stated annual rate. Directors should confirm which convention applies when comparing facilities from different lenders.

Flat rates versus effective annual rates

A flat rate is applied to the original advance across the full term, regardless of how much principal has been repaid. Because the borrower progressively repays capital, the effective annual rate (EAR) — which reflects the true cost on the declining balance — is roughly double the stated flat rate for a fully amortising loan. Quoting a flat rate can make a facility appear cheaper than it is.

UK commercial lenders are not legally required to quote APR to limited company borrowers in the same way they are for consumer credit, so directors must scrutinise whether a quoted rate is flat or a reducing-balance equivalent. Asking for a full amortisation schedule with total interest paid is the clearest way to compare two facilities on equal terms.

Capitalised versus non-capitalised interest

Some commercial facilities — particularly development finance and certain bridging loans — allow interest to be rolled up and added to the loan balance rather than paid monthly. This is known as retained or capitalised interest. The outstanding balance grows over the term, meaning interest accrues on interest that has already been rolled in. Directors should model the terminal balance carefully and confirm the lender's compounding frequency before committing.