How To Understand APR: The Difference Between APR and Interest Rate

You’ve probably encountered both interest rates and APRs when researching different types of small business financing. But what do the numbers mean and what can they tell you about the amount you’ll be paying? Here’s what you need to know.

 

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What is Interest Rate?

An interest rate is a percentage that reflects the cost of borrowing the loan amount. Interest rates can be variable or fixed, depending on if they change throughout the term of the loan.

What is APR?

The Annual Percentage Rate (APR) is the total rate you’ll be paying on a yearly basis for your loan. This includes the interest rate, fees, closing costs, and any other additional charges associated with your desired loan.

The APR is also expressed as a percentage, but will often be higher than the base interest rate since it takes even more into account.

How does APR work?

APR works by factoring all loan payments – not just interest – into your costs. This provides a more comprehensive picture of what you’ll owe to your lender on top of your loan. For example, an APR of 20% on a $10,000 loan means that, over five years, you can expect to pay approximately 5*(0.2*$10,000) = $10,000. As a result, your five-year $10,000 loan with an APR of 20% actually costs double what you might initially expect.

Additionally, APR values may differ by the borrower. That’s because lenders often customize APRs to reflect their borrower’s riskiness. For example, a borrower with a poor credit score or history may be given a higher APR than one with a strong credit history. When you apply for a loan, other factors that determine your APR may include your loan type and current debts.

How to Calculate APR

Sometimes, lenders will only share your loan’s interest fee and not list an APR. An excluded APR, though, doesn’t mean that your loan lacks an APR. In fact, APRs are by definition a part of every loan since they reflect all the fees that accompany your loan. Additionally, some lenders have a reputation for hiding fees in their contracts, which is why you won’t always see APRs – but you can always calculate them.

To do so, take the following steps:

  1. Use your interest rate to determine the total interest you’ll pay over the life of your loan. For example, for a $50,000 two-year loan with a 5% interest rate, you’ll pay 2*(0.05*$50,000) = $5,000 in interest during your loan term.
  2. Determine the total fees you’ll pay over your loan’s lifetime. As you calculate this sum, include both recurring fees and one-time costs such as application fees.
  3. Add your total interest and fees, then divide this sum by your total loan amount.
  4. Divide this fraction by the number of days in your loan term.
  5. Multiply this fraction by 365, then by 100%. The result is your APR.

The below formula neatly summarizes the above steps:

APR = {[(total interest + total fees)/loan amount]/number of days in loan term} * 365 * 100%

Using this formula, if your $50,000 two-year loan generates $5,000 in interest and $2,000 in fees, your APR is:

APR = {[($5,000 + $2,000)/$50,000]/(365*2)} * 365 * 100% = 7%.

Notably, compounding interest is not a part of APR calculations. If compound interest is part of your loan, speak to your loan provider or a small business finance expert about how you can determine your APR, as the above formula only works for simple interest.

Types of APR

There are two different types of APRs you should concern yourself with when you take out a loan for your small business:

  • A variable APR fluctuates in value with time, often without warning. It will follow the prime rate that the Federal Reserve sets. You can usually find this rate in the Wall Street Journal.
  • A fixed APR is typically set in stone unless you trigger a term in your loan agreement that changes it. If you miss a loan payment, your APR could change, just as it occasionally could if the market changes. In either case, your lender must notify you before your APR change goes into effect.

Even if you forgo loans for your business, you should know about APRs in the context of credit cards, as credit card companies are known to set rather high APRs. Credit card APRs that you should know include:

  • Purchase APRs. These are the most common type of credit card APRs. You can avoid them by paying your balance in full by its due date, as clearing your credit card balance means you have no active loans generating interest. However, if your card membership includes monthly fees, you’ll have to pay those no matter what.
  • Balance transfer APRs. If you transfer your card’s balance to another credit card, your APR will apply when you initiate the transfer, and it will have no grace period. The more often you transfer your balance, the more likely your card provider is to increase your APR. A separate balance transfer fee may apply.
  • Cash advance APRs. If you use your credit card at an ATM to get cash, you will be charged a cash advance APR. These APRs are often high, and a separate cash advance fee may also apply.
  • Penalty APR. If you miss a payment or pay late, your APR will increase, and this new rate is known as a penalty APR. In some cases, you can lower your rate to its initial value if you consistently make timely monthly payments moving forward.
  • Introductory APRs. Chances are that you’ve seen introductory APRs without knowing the term. Any time you see an offer for a credit card with no APR for its first 12 months, you’re seeing an introductory APR of zero. After the introductory period expires, your account will begin to include the purchase APRs common with credit cards.
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What is the Difference Between APR and Interest Rate?

The main difference between the two rates is that while the interest rate is associated with the expected monthly payment, the APR reveals the total cost of the loan, including one-time fees. This means that if you use the interest rate to calculate the cost of your loan, you may miss the bigger picture. The lack of additional costs factored into the interest rate could cause you to agree to a loan that you can’t quite afford. Using APR instead incorporates all possible costs.

When do they matter?

Both interest rates and APRs are important when you’re evaluating different financing options. As long as all other factors like the term and amount of the loan remain the same, knowing how much you’ll be paying regularly can help you make a decision.

Each number will tell you about slightly different aspects of the repayment process.

Which one should you use?

Depending on what you’re looking to zero in on, you can use either percentage to get a fair comparison between different offers.

If you’re interested in finding out the amount you’ll be paying every month, use the interest rate as your point of comparison. Doing so makes calculating your costs easier, as determining your interest only requires some multiplication. To use the same two-year $50,000 loan with 5% interest as an example, your monthly loan payment will be $2,083.33, with interest of 0.05*$2,083.33 = $104.17. As such, your total payment is $2,0833.33 + $104.17 = $2,187.50.

But if you’re concerned about hidden fees and the true overall cost of the loan, APR is the way to go. For the aforementioned loan, an APR of 7% means that beyond your $50,000 loan, you’ll pay 2*(0.07*$50,000) = $7,000 extra. Spread across two years, this $7,000 means an extra $291.67 per month. This means that your total monthly payment isn’t just $2,187.50 but instead $2,083.33 + $291.67 = $2,375.

It’s a good idea to have both percentages in mind, because they each reveal something slightly different. In conjunction, they’ll help you understand where your payments will be originating from: the monthly (or weekly, or daily) interest, or the one-time fees associated with closing, packaging, and servicing.

SmartBiz Interest Rates and APRs

At SmartBiz Loans, we believe in 100% transparency. We’ve broken down all rates and fees for an SBA loan from our bank partners. Check out these handy Working Capital, Debt Refinance, and Commercial Real Estate loan calculators so you can determine the interest rate and APR associated with the loan amount you need.

Because of the long terms low rates and no pre-payment penalties, offered by the Small Business Administration through their 7(a) loan program, it’s no wonder this funding is known as the gold standard in small business lending. SmartBiz is here to help you get to a “yes” on your SBA loan application.

Before you apply, get started with SmartBiz Advisor to get a closer look at your lending profile, as well as personalized recommendations on how to improve your situation if necessary. This free, educational tool will act as your Intelligent CFO and help you understand how our bank partners evaluate your business.

* The information provided through SmartBiz Advisor, including the Loan Ready Score, is for educational purposes and is not the same as scores used by lenders for credit decisions. SmartBiz Advisor is not a financial or legal advisor as defined under federal or state law. Use of this information is not a replacement for personal, professional advice or assistance regarding your finances or credit history.

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