APR vs Interest Rate: Which Should You Use to Price a Loan?
If you’re shopping for a small business loan, you might become confused by the terminology. Two frequently confused phrases include APR (annual percentage rate) and interest rate. If you’re not sure how to define APR vs interest rate, you’re not alone. However, once you learn the difference between these two numbers you’ll be better prepared to start shopping for a loan.
APR vs Interest Rate: What’s the Difference?
APR and interest rate are two similar but different things. Your interest rate is the cost you will pay to borrow money. It only includes the interest percentage you will be charged for borrowing the money, and it does not include any other fees you might be required to pay on the loan.
APR stands for annual percentage rate. The APR of a loan gives you a more comprehensive look at how much you’ll pay when you borrow money for a loan. Basically, it’s the total price of borrowing money expressed in terms of an interest rate. That means it includes the cost of interest plus additional fees. Additional fees that may be included in your APR include: points, closing costs and loan origination fees.
How Can I Calculate Interest to APR?
In many cases, your lender will provide you with the APR when you apply for a loan. If you want to figure it out for yourself, you can use spreadsheet formulas and online loan calculators to plug in the numbers you already know. You might be surprised at how much your APR can fluctuate when any one of the variables in the calculation is changed.
To calculate APR, you need to know the interest rate of the loan, the total amount you plan to borrow, the repayment terms, and the cost of any fees. To illustrate how it works, let’s assume that you’re going to borrow $10,000 and that you’ve been quoted an interest rate of 12%. You will also have to pay a $500 closing fee. The APR on your 2-year loan would be roughly 16.92%. Let’s see how we got that number.
The simplest way for you to calculate APR on any loan is to use a loan calculator or a spreadsheet. For instance, in Google Spreadsheets, you can calculate the monthly payment and closing costs for the scenario described above with built-in formulas.
1. Type the following formula into any cell to calculate the monthly payment for your loan:
=PMT(interest rate/months, total number of months you pay on the loan, loan value plus fees)
=PMT(.12/12, 24, 10500)
Your monthly payment would be $494.27
2. Once you have determined the monthly payment, you can use a second formula to determine your APR:
=RATE(total number of months you pay on the loan, your monthly payment expressed as a negative, the current value of your loan)
=RATE(24, -494.27, 10000)
3. Your monthly rate should be .0141. Multiply by 12 to get an annual rate:
.0141 * 12 = .1692
4. Finally, multiply by 100 to convert from a decimal back to a percentage:
.1692 * 100 = 16.92%
What Can Affect Your APR?
Lenders will use several things to determine your APR on a loan, including the type of loan for which you are applying, your credit history, and your current borrowing ratio. If lending to you seems like a low-risk endeavor, the bank will most likely offer you a lower APR in order to win your business. On the flip side, if you are a high-risk borrower, you will be quoted a higher APR.
It’s also important to know that some loans just cost more than others. Think of a home loan for instance. A 15-year loan typically has a lower interest rate than a 30-year loan because it will be paid off more quickly. You can also see how rates vary when you compare two different loan types such as home loans and credit cards. Credit cards are unsecured (or not backed by specific collateral) and, as a result, riskier; therefore the APR on cards are generally much higher than home loans.
As a small business owner, your personal and business credit history will affect the APR you are quoted for loans. If you have a poor track record of paying back loans or you have a high debt-to-income ratio, your risk—and your APR—will increase.
APR vs Interest Rate: Which Should I Use to Price My Loan?
Evaluating loans from different lenders is much easier when you compare the interest rate and the APR. It’s important to know the basic interest rate you’re being quoted for a quick comparison. However, APR is what will reveal the true cost of the loan (especially if you are looking at short-term loans). APR takes into consideration the other costs and fees associated with borrowing money, as well as your repayment terms. By assessing the APR, you can more accurately compare the total costs of each loan offer and choose the one that’s best for you.
When it comes to the difference between APR vs interest rate, it’s critical you understand what makes them each unique. Most importantly, don’t ever just ask for the interest rate. Always ask a lender what the interest rate AND APR are before committing to a loan. (And use a business loan calculator to calculate it yourself if you have to).
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