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