Small business loan terminology is complex, and many of the terms are similar enough to be confusing. Two such phrases are APR (Annual Percentage Rate) and interest rate. Learning the difference between these two numbers will help you when it’s time to start shopping for a business loan.
What’s the Difference?
While APR and interest rates are similar, there are important differences between the two. Interest rate is how much you’ll have to pay back on your loan. It only includes the percentage of interest you’ll be charged, leaving out other fees and expenses associated with borrowing, which can be substantial.
APR, on the other hand, gives you a much more complete idea of how much it will cost to borrow. It combines the loan interest and other fees, including points, closing costs and loan origination fees. With APR, the total cost of the loan is expressed as a percentage, rather than just the interest payments you’ll be making.
How Can I Figure Out APR?
Most of the time, your lending institution will provide the total APR when you apply for a loan. Spreadsheets and online calculators are available if you want to figure it out yourself from information that you’re given, however. Fluctuations in APR can be large when just a single variable is changed in these equations, so it’s important to re-adjust your estimates if your loan terms change before closing.
To calculate the APR of your loan, you’ll need a few critical pieces of information:
- Interest rate
- Principle you plan to borrow
- Repayment terms
You can easily build a spreadsheet in Google Spreadsheets or Microsoft Excel using built-in formulas to calculate your total APR.
Four Steps to Calculate Your APR
Here’s an example. Let’s say that you’re looking to take out a loan for $10,000 with an interest rate of 12 percent. It’s a two-year loan, and the closing fee is $500.
A. Calculating Monthly Payment: To calculate the APR, you first need to calculate your total monthly payment. You can use this formula for our example loan: =PMT(.12/12,24,10500)
The resulting payment is $494.27.
To calculate the monthly payment on any other loan, simply substitute the numbers you’re using for the ones from the example. Your formula will be: =PMT(interest rate/12, duration of the loan in months, total loan value)
B. Calculating APR: Once you have your monthly payment, you can use a second formula to calculate your total APR. For our example, the formula looks like this: =RATE(24,-494.27,10000)
The resulting monthly rate is 0.141.
You can multiply that number by 100 to get your monthly interest rate, which would be 1.41 percent. To find your total annual APR, simply multiply your monthly rate by 12. The result is .1692, or 16.92 percent.
For any other loan, just substitute the correct numbers: =RATE(total number of months of the loan, monthly payment as a negative number, total value of the loan)
To conclude, the APR is significantly different from the interest rate of the loan, which is only 12 percent.
What Affects APR?
Many factors influence APR, including the kind of loan you’re looking for, your current debt to credit ratio and your credit history. If a bank or other institution feels that there’s little risk in providing you with a loan, they’ll offer a lower APR. On the other hand, if they think your loan is risky, expect to pay a significantly higher APR.
Your credit isn’t the only factor, though. Some loan types are more expensive across the board. For example, shorter loans tend to have lower interest rates because they’ll be paid off more quickly. Credit cards also usually have higher interest rates than home loans because they’re unsecured, making them riskier for lenders.
When you’re looking for a business loan, both your business’s credit history and your personal credit history will be used to determine your eligibility and rates.
Should I Use Interest or APR to Price My Loan?
The short answer is that you should use both. Interest rate provides a quick comparison when you’re shopping for loans, but APR will tell you the total, actual cost of the loan, especially for short-term loans where fees are a bigger part of the picture. APR takes all of these costs, including your repayment terms, into account, which lets you more directly compare the costs.
It’s important that you understand the difference between APR and interest rates. Interest rates can make it seem like borrowing is less expensive than it truly is. Before you commit to any loan, make sure you know both the interest rate and the APR.