Loan Interest Expense

When auditing a client model one of the most common mistakes can be found within the debt section, specifically the interest expense. Often the issue lies within calculating the loan interest expense.

What is Loan Interest Expense?

Loan interest expense is a cost that is incurred when borrowing funds. Interest expense is a non-operating expense and is included in the levered cashflow section of a cashflow model. This non-operating expense can be found on the income statements and occasionally balance sheets. The loan interest expense can be paid on a current asset, which occurs as a prepaid interest expense, or on a current liability, which occurs as interest payable. The interest rate on a loan varies depending on the specific type of loan. For example, a typical interest rate for a construction loan in real estate varies from 4.25% - 5.5% on average. But, for a mezzanine loan, the interest rates can reach as high as 13%.

How to Calculate Loan Interest Expense

The loan interest expense is calculated based off the outstanding loan amount.

For example, let’s say that you are taking out a $1,500,000 loan with a 4.5% interest rate that will be paid monthly.

An interest expense amount of $5,625 will be paid monthly. If the interest is paid annually, instead of dividing by 12 (monthly) one would divide by 1.

Below is an example of how Top Shelf Models (TSM) calculates construction interest in our models. The first part of the statement with the blue font, makes sure that the interest is calculated within the beginning and end months of the loan. If the months are outside of the start and end dates, the interest will not calculate. The next part of the statement calculates the interest for that period. The construction interest loan has three different kinds of methods to determine the interest amount for that period. The first method is by dividing the interest by 360 days and then multiplying that amount by the number of days that have passed between the current period and the previous period. The second method is roughly the same except instead of dividing by 360 days, you would divide by 365 days. The third method divides the interest amount by 360 days and then multiplies the interest by 30 days. One would have to read the loan documents carefully to determine which method is the most accurate. Once the interest is determined, the formula then multiplies the interest by the current periods beginning balance.

Loan Interest Expense Methods

In real estate there are two main methods to determining the interest rate.

The first method is when the interest is fixed. A fixed interest rate is when the rate is constant and does not change during the duration of the debt obligation.

In contrast to the fixed interest rate method is the floating interest rate method. A floating interest rate is an interest rate that vacillates with the market or an index. A determined interest spread is added to the market index. At TSM we utilize the LIBOR curve as our market index. LIBOR is a short-term floating rate at which large banks with high credit ratings lend money.

In either interest expense method, interest expense will decrease as principal on the loan outstanding is paid down. Thus, your interest expense at the beginning of the loan period tends to be higher than when you’re closer to the maturity of the loan.

Loan Interest Expense in Real Estate

It is important to include accurate debt schedules in financial models to accurately represent the returns. At TSM we calculate an interest reserve by offsetting the interest expense with positive NOI. Depending on the project assumptions, the interest reserve can be equal to the interest amount or less than the calculated interest if there is positive NOI during that period. Whenever a construction loan or acquisition loan is taken out for a project, one must be sure to include the interest amount when calculating the loan or the project will run out of money before it even gets off the ground.

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About the Author

Eric Bergin is the founder of TSM. He realized that there was a need for real estate financial models that were more than just generic templates. He wanted to create a personalized product for his customers that would ensure success for them and their company. Please reach out to him if you have any questions on loan interest expense or if he can help you with your modeling needs.