Maximizing Your Estimated Return on Investment for a Loan

Taking out a loan for a major purchase or investment can be a great way to get the capital you need upfront. However loans also come with interest and fees that cut into your potential returns. Calculating the estimated return on investment (ROI) for a loan upfront can help you evaluate if the loan is worth it and maximize your ROI.

What is Estimated ROI for a Loan?

The estimated ROI for a loan is a forecast of the potential profit you could earn from the money borrowed after accounting for the total costs of the loan. It allows you to quantify on a percentage basis whether the opportunity enabled by the loan is likely to generate sufficient returns to justify the interest expense.

For example say you get approved for a $50,000 business loan at 6% interest to be repaid over 5 years. You plan to use the capital to invest in new equipment that you forecast will increase your annual profits by $15000. To calculate the estimated ROI

• Total Returns = $15,000 x 5 years = $75,000
• Total Cost = $50,000 principal + (0.06 x $50,000) x 5 years interest = $65,000
• ROI = (Total Returns – Total Cost) / Total Cost x 100 = ($75,000 – $65,000) / $65,000 x 100 = 15.4%

An estimated ROI of 15.4% suggests the equipment investment enabled by the loan will generate sufficient incremental profits to provide an acceptable return even after accounting for interest costs.

Why Calculate Estimated ROI on a Loan?

Taking the time to forecast ROI can help you

• Evaluate if a loan-funded investment or purchase will generate enough incremental value to justify the interest expense. An ROI below your hurdle rate would indicate the loan is not worthwhile.

• Compare ROI across different loan options to select the best loan terms. The loan with the highest ROI may not have the lowest interest rate once you factor in fees, collateral requirements, and repayment schedule.

• Identify the most impactful levers to improve ROI. For example, maybe you can negotiate a lower interest rate, extend the repayment term, or reduce collateral requirements.

• Make adjustments to improve ROI. If the initial ROI is too low, you may be able to modify the investment plan to increase returns.

• Communicate a credible business case to lenders. An ROI forecast can help demonstrate to lenders that their capital will be put to productive use.

In short, taking a systematic approach to estimating ROI can help ensure any loan you take maximizes value for your business.

How to Calculate Estimated ROI on a Loan

The general formula for calculating estimated ROI on a loan is:

(Total Returns – Total Costs) / Total Costs x 100

Where:

• Total Returns = The total monetary benefits generated by the investment over the loan term
• Total Costs = The total loan amount including principal, interest, fees, and other costs

Let’s break this formula down using a simple example. Say you get a $20,000 small business loan at 8% interest to purchase a new machine for your manufacturing facility. Here are the steps to estimate ROI:

1. Project Total Returns

   • Forecast the incremental profits the machine will generate each year
   • Sum the incremental profits over the loan term
   • For example, the machine adds $6,000 in profit per year. The loan term is 4 years. So Total Returns = $6,000 x 4 years = $24,000.

2. Calculate Total Costs

   • Start with the loan principal
   • Add the total interest charges over the loan term
   • Include any upfront fees or closing costs
   • For example, the $20,000 principal at 8% over 4 years accrues $3,200 in total interest. Adding the $20,000 principal and $3,200 interest gives Total Costs of $23,200.

3. Plug the Total Returns and Costs into the formula

   • (Total Returns – Total Costs) / Total Costs x 100
   • ($24,000 – $23,200) / $23,200 x 100 = 3.4% ROI

This estimated ROI of 3.4% provides an objective benchmark to evaluate whether the incremental profits justify taking on the loan. The next section provides tips for maximizing ROI in your estimate.

How to Maximize Estimated ROI on a Loan

Here are some best practices for maximizing the estimated ROI on a loan-funded investment:

• Use conservative assumptions for returns – Avoid inflated forecasts by basing projections on reasonable growth rates and margins. This provides a more objective ROI assessment. Sensitivity analysis can show ROI under best/worst case scenarios.

• Account for the full costs – Factor in all interest, fees, collateral requirements, and overhead costs attributed to the loan. Hidden costs reduce ROI.

• Model the repayment structure – Structure the forecast cash flows to mirror the actual loan amortization schedule. Front-loaded payments reduce short-term returns.

• Optimize the loan term – Match the loan term to the useful life of the investment. Too short and returns won’t cover costs. Too long increases interest costs.

• Compare loan options – Contrast the ROI across different loan products, lenders, and terms. Don’t assume the cheapest rate is best.

• Identify opportunities to improve returns – Review if adjustments to the investment plan could increase returns and ROI without increasing risk.

• Negotiate better loan terms – Shop around and negotiate the best possible interest rate, fees, collateral policy, and repayment structure.

• Assess ROI versus hurdle rate – Determine the minimum ROI threshold for loan-funded investments based on your cost of capital and risk tolerance.

• Re-evaluate regularly – Monitor actual results versus forecasts and adjust ROI assumptions as needed. Update projections with new information.

Taking these steps will provide confidence that your loan-funded investment will generate strong returns that sufficiently compensate you for the cost and risk taken on.

Examples of Calculating Estimated ROI on Different Loan Types

Let’s walk through some examples of estimating ROI for common loan types:

Business Loan ROI

John takes a $100,000 small business loan to expand his medical supply retail store by adding a new showroom. The loan has a 10 year term at 7% interest. John forecasts the expansion will generate $20,000 in additional annual profit.

• Total Returns = $20,000 x 10 years = $200,000
• Total Costs = $100,000 principal + (0.07 x $100,000) x 10 years interest = $170,000
• ROI = ($200,000 – $170,000) / $170,000 x 100 = 17.6%

The 17.6% estimated ROI exceeds John’s 12% hurdle rate, so the business loan is justified.

Mortgage Loan ROI

Jane takes a $300,000 30-year mortgage at 5% interest to purchase a rental property for $340,000. Jane forecasts rental income of $1,500 per month and total annual expenses of $8,400.

• Total Returns = ($1,500 x 12 months x 30 years) – ($8,400 x 30 years) = $486,000
• Total Costs = $300,000 principal + (0.05 x $300,000) x 30 years interest = $495,000
• ROI = ($486,000 – $495,000) / $495,000 x 100 = -1.8%

The negative ROI indicates the costs outweigh the returns, meaning Jane would lose money. The rental property would not be a good investment with a mortgage at the current terms.

Auto Loan ROI

Bob takes a $15,000 auto loan for 5 years at 4% interest to purchase a delivery van for his catering business. He forecasts the van will save $3,600 in annual rental costs.

• Total Returns = $3,600 x 5 years = $18,000
• Total Costs = $15,000 principal + (0.04 x $15,000) x 5 years interest = $16,500
• ROI = ($18,000 – $16,500) / $16,500 x 100 = 9.1%

The 9.1% ROI suggests the cost savings from purchasing versus renting the van justifies the auto loan.

Key Takeaways on Estimated ROI for Loans

• Calculate estimated ROI upfront to evaluate if a loan-funded investment or purchase will generate sufficient incremental returns to warrant taking on debt.

• Use the formula (Total Returns – Total Costs) / Total Costs x 100, where Total Returns equal the forecast monetary benefits over the loan term and Total Costs equal principal, interest, and fees.

• Maximize ROI in your forecast by using conservative return estimates, factoring in all costs, modeling the repayment structure, optimizing the loan term, comparing loan options, identifying return improvement opportunities, negotiating favorable loan terms, and assessing ROI versus your hurdle rate.

• Re-evaluate regularly by updating return assumptions and rerunning ROI projections as actual results come