Comparing small business financing products such as business loans can seem like one big numbers game. To simplify things, pay attention to 2 key figures when you’re out shopping around.
Two of the most important numbers to take into account are the interest rate and annual percentage rate (APR) of the financing products you’re considering.
While these terms might sound interchangeable, there is actually an important difference you should understand. The interest rate (sometimes called the nominal or simple interest rate) reflects the percentage of interest that will be charged on the loan. For instance, if you borrow $10,000 at 5% interest, the total interest you’ll pay is $500.
However, the interest rate is not a true measure of the cost of borrowing money. That is shown by the APR. The APR (sometimes called the effective interest rate) reflects the percentage of interest you’ll pay each year when additional loan costs, such as closing fees, documentation fees, and origination fees, are rolled in. As a result, the APR is always higher than the interest rate. (Well, almost always. More on that later.)
It’s important to understand both interest rate and APR so that you can compare apples to oranges when choosing a business loan. If you base your decision solely on the loan with the lowest interest rate, you might end up paying more in the long run.
Unfortunately, not all lenders advertise APRs on small business loans. In fact, they may not even provide that information when you apply for a loan. It’s not that lenders are trying to hide something. Rather, it’s because the APR the lender is willing to offer may vary depending on factors specific to you, such as your business credit rating and your business’s current debt load.
In other words, there is no one-size-fits-all APR that applies to every person applying for a particular business loan. (Remember earlier when I said that the APR of a loan is almost always higher than its interest rate? For some types of loans, such as auto loans and home loans, lenders may offer rebates that can lower your APR below your interest rate.)
APRs will also vary depending on the life of the loan. For example, even if an 18-month loan and a 10-year loan have the same interest rates and fees, they will have very different APRs. That’s because the 10-year loan spreads out the fee repayment period over a much longer timeframe, lowering its APR substantially compared to the 18-month loan.
Do you want to get a ballpark idea of a loan product’s APR before you apply, but the lender isn’t sharing? If you know the interest rate, amount you plan to borrow, repayment term, and total fees, you can use this formula to calculate APR.
While APR and interest rate are both important numbers to know when evaluating a business loan, they aren’t the only factors to take into account. You should also consider the loan term, repayment schedule, ease of obtaining the loan, and any potential penalties (such as for missed payments or prepayment).
Don’t go solely by the numbers—look at the bigger picture of how the loan will fit into your overall business finances. Only then can you decide which option suits you best.