Businesses needing to take on a loan often focus their attention on the interest rate. But it’s not quite that simple. The truth is, interest rates and APRs are not interchangeable. This is not just an academic distinction. You want to understand exactly how much it will cost to borrow money, which will also help you compare offers between lenders. Let’s take a look at the difference between interest rates and APR.
An interest rate is the amount that you pay for borrowing money. It is expressed as a percentage of the amount you borrowed. You have to pay an interest rate when you borrow money because, in effect, you are renting the money, and you have to pay “rent” to use it. There are plenty of online calculators that can help figure out the interest on a loan. One commonly used calculator is from Bankrate. The advantage of using a loan calculator is that it takes the math out of the process. If you would rather work it by hand, the simple interest formula for a basic loan is Interest = Principal × Rate × Time, with time in years (convert the percent into a decimal by dividing by 100, so 6% becomes .06). A $50,000 loan at 6% over one year comes to $3,000 in total interest.
APR gives you more information about the cost of your loan than just the interest rate. It factors in the interest rate, plus other charges your lender may have. APR is the combination of interest rate and fees, all rolled into one yearly number, which reflects how much a loan costs you. The difference is that the interest rate represents the basic cost of the debt, while the APR represents the total cost, and gives a better understanding of how much you will have to pay. The more fees a lender charges, the higher the APR.
To understand the difference between interest and fees, think of it like this. The interest rate is how much money you must pay the lender. The fees are how much it costs you to do business with the lender. Lenders add fees to cover the cost of processing applications or managing loans. The amount may vary based on your lender and the type of loan. Fees might include lender origination fees, application fees, annual fees and late payment fees. Some are a flat dollar amount, while others are a percentage of the loan. This is why it’s important to ask lenders about all their fees when you are shopping for a loan. It’s easy to compare loans just by looking at the interest rates because that number tells you what you have to pay. But for a true comparison, you should look at the APR for each lender. APR is a more complete snapshot of what you will actually have to pay, and it accounts for all the fees associated with your loan.
Short term loans are a good example of this confusion. Because you’re borrowing the money over a short period, you pay less interest overall. These loans make up for it with higher APRs, which means higher total costs of borrowing once fees such as origination fees are counted. If you just look at interest rates, it’s possible to be misled. Some loans offer low interest rates but pile on additional charges. That all adds up, so be sure to read the fine print to make sure you know the true cost of a loan, not just the interest rate.
Lenders are legally required to provide APRs for consumer loans. If you take out a business loan, there is no requirement to publish the APR. Lenders are welcome to disclose their APR, and many do. If one doesn’t give you an APR up front, ask for it. When shopping around for a business loan, don’t just compare interest rates, also compare APRs.
Not every lender quotes an APR, either. Many rely on factor rates, flat fees, weekly charges or the prime rate instead. Interest rates can be fixed or variable, and APRs are not always provided.
A fixed interest rate never changes. With a variable interest rate, the number is allowed to go up or down based on some benchmark. Fixed interest rates typically lock you into your current rate, which is a good thing when interest rates rise. Your payment doesn’t change; you are protected from higher rates. However, you will never reap the benefit of lower interest rates, either. A variable rate may start out lower, but the flipside is that you risk paying more for a loan if rates increase, which can make it difficult to budget.
So, if you get quoted a high interest rate, ask yourself, “Why?” Lenders factor in risk when determining an interest rate, so if they view your business as risky, they are likely to charge a higher interest rate. Lenders usually weigh many factors, including your personal credit score, your company’s credit score and your cash flow. As a general rule of thumb, the stronger your credit profile, the better your rates will be. Lenders also look at how long you’ve been in business, since new businesses are considered riskier, and at your industry, since riskier industries usually mean higher rates. Collateral counts too. When a lender provides you with a loan, it assumes a risk. Using your collateral lowers the lender’s risk. When the lender’s risk decreases, it has an incentive to reduce the interest rate you are charged.
Most financial institutions offer business loans, but you may find yourself paying different interest rates and APRs depending on where you go. SBA loans and traditional bank loans typically offer the lowest rates but require the highest qualifications, and banks tend to be the slowest to fund. An online lender is likely to be faster and easier to qualify for, but online lenders may charge higher rates and APRs.
In general, it makes sense to aim for the shortest loan that is feasible for your business, so you get out of debt sooner and pay less interest. But don’t set yourself up for failure by stretching your budget too far. Look carefully at your cash flow and how the payments will fit in. Check out the interest and fees, the APR and the overall length of the loan. Missing payments can lead to financial penalties or, in extreme cases, the lender seizing your collateral.
When choosing a loan, and your options are limited, you need to understand exactly how much you will have to pay back in order to get the money you need. Interest rates and APRs might be confusing at first, but it is important to understand the difference between the two before accepting any offer. The interest rate tells you what the money costs. The APR tells you what the loan costs.
