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When you take out a loan, your interest rate represents the interest percentage you will be charged for borrowing the money, but does not include origination fees, closing fees, documentation fees, and other finance charges. Annual percentage rate (APR), on the other hand, gives you a more comprehensive look at how much you’ll pay when you borrow money for a loan by factoring in these costs and expressing the total price of borrowing money in terms of an interest rate. When it comes to these two concepts, the APR more accurately represents the true cost of the loan.
If you’re shopping for small business loans, you might become confused by all the terminology that gets thrown your way. With factor rates, P&Ls, debt schedules, APY (annual percentage yield), real vs nominal interest rates, all your business loan requirements come with a fair share of confusion. Two terms that are particularly misunderstood are annual percentage rate vs. interest rate.
So let’s talk about them.
Just like knowing the difference between a fixed-rate mortgage and an adjustable-rate mortgage, it’s important to learn how annual percentage rates and interest rates differ. If you’re not sure how to define annual percentage rate 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.
Annual percentage rate vs. interest rate: These are two similar but ultimately different things. Let’s work out a definition for both.
Your interest rate is the cost you will pay to borrow money. When it comes to a mortgage loan, you can get a fixed-rate mortgage or an adjustable-rate mortgage. The interest rate 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—think origination fees, closing fees, documentation fees, and other finance charges.
APR stands for annual percentage rate.
In the United States, the disclosure and calculation of this rate has been governed by the Truth in Lending Act. The U.S. Department of the Treasury provides the following in regards to how the act protects consumers:
“The Truth in Lending Act (TILA) protects you against inaccurate and unfair credit billing and credit card practices. It requires lenders to provide you with loan cost information so that you can comparison shop for certain types of loans.”
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. In other words, those closing fees, origination fees, documentation fees, or other finance charges are accounted for in this rate.
So with APR vs. interest rate, your interest rate just shows the base cost of borrowing money and your APR shows the total cost of borrowing money. Therefore, your APR will typically be a quarter to even a half point higher than your interest rate will be. This is not to be confused with APY, which is your annual percentage yield.
In many cases, your lender will provide you with the APR when you apply for a loan. But in some cases, you’ll just be given an interest rate. And if you only have an interest rate but know that you’re paying more in fees, then you should get a sense of what your APR will be.
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 annual percentage rate, here’s what you need to know:
But how do you put this information together to turn your interest rate into your annual percentage rate? Well, to illustrate how it works, let’s assume the following: You’re going to borrow $10,000 and 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 this rate 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. Here are the steps you need to follow to get the right APR.
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(0.12/12, 24, 10500)
Your monthly payment would be $494.27.
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)
This gives a monthly rate of 0.0141.
Multiply your monthly rate (0.0141) by 12 to get an annual rate:
0.0141 * 12 = 0.1692
Your annual rate—not expressed in percentage form—is 0.1692.
Finally, multiply by 100 to convert from a decimal into a percentage:
0.1692 * 100 = 16.92%
Your APR is 16.92%.
When you finally work through your rate, you’ll find that your original interest rate of 12% doesn’t truly reflect the rate you’ll get on your loan when you consider the fees you’ll pay. Instead of a 12% interest rate, you’ll get a 16.92% APR.
Complicating matters is that there is more than one type of APR. With credit cards in particular, there are different APRs depending on how you use your card. Let’s take a look at each one:
Along with the different types APRs, you can also have a variable or non-variable interest rate, which will have a direct impact on your APR. A non-variable interest rate means your rate stays the same indefinitely. It also means you have a non-variable APR. A variable interest rate means your interest rate can fluctuate over time. The variable rate is calculated by adding the margin, set by the credit card company, to the index (or reference rate), such as the Prime Rate. If the Prime Rate increases, so will your interest rate (and therefore your APR). Conversely, if the Prime Rate decreases, your interest rate and APR will follow, thus making it cheaper for you to borrow money.
Why is your APR the percentage it is? How does a lender calculate the rate on your loan?
Well, 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 (meaning how much debt your business currently owes).
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. So in the case that you can’t repay your loan, the lender has already made up for most of the money they’ve lost by charging you a steep APR on the funds.
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. When you have a home loan for a shorter term, the lender takes on less risk—their money is loaned out for a shorter amount of time.
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. Collateral helps ensure the lender that they’ll get their money back in the case you can’t pay back what you borrowed. In the case of a default, the lender can just seize the collateral to recoup their losses. But with a lack of collateral backing credit card debt, 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.
Evaluating loans from different lenders is much easier when you compare the APR vs. interest rate. It’s important to know the basic interest rate you’re being quoted for a quick comparison between loans.
However, APR is what will reveal the true cost of the loan (especially if you are looking at short-term loans). This rate takes into consideration the other costs and fees associated with borrowing money, as well as your repayment terms. By assessing this rate, you can more accurately compare the total costs of each loan offer and choose the one that’s best for you. The take away is this: If you want to compare apples to apples for business loans, then you need to know each loan’s APR.
When it comes to the difference between annual percentage rate 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 annual percentage rate are before committing to a loan. (And use a business loan calculator to calculate it, along with the effective interest rate, yourself if you have to).
Don’t fall into a high-priced business loan by simply looking for the lowest monthly payments or the cheapest interest rate. There’s more going on beneath those low-number figures. To be confident that you’re getting the lowest cost business financing out there, use APR to price your business loan—it’s the most transparent way to show how much you’ll be paying your lender back.