APR vs. interest rate
While APR stands for annual percentage rate and represents the rate to borrow money, APR is in fact different from the interest rate—the percentage a lender charges on your business loan or credit card.
The interest rate is a percentage charged on the loan principal—the money you’ve borrowed. This percentage is only a part of your APR.
The rest of the APR is made up of fees the lender charges when you take out your loan or use your credit card. Those fees get lumped together with the interest amount and you pay both down simultaneously, in installments.
APR shouldn’t be confused with APY (annual percentage yield), which takes the compounding of interest into account.
Why does APR matter?
If you focus solely on either APR or interest when picking a loan or credit card, you could miss out on the chance to save money—or even end up paying more than you expected.
Also, you may have different APRs depending on what types of borrowing you’re doing. Most commonly this is the case with a business credit card. The APR you pay on a cash advance or balance transfer could be more or less than your regular purchase APR. These may or may not be relevant to your business—cash advance APR shouldn’t play a big role in your decision making unless you plan to use lots of cash advances.
In some cases, a card with a 0% introductory APR grace period may be more attractive than one with a better overall credit card APR. You can make use of the introductory rates to make new purchases for your business early on. As long as you pay off the debt before the introductory period is over, you’re essentially borrowing money for free.
If you fail to make your repayments or spend beyond your credit limit, the credit card company may charge you a penalty APR on the extra outstanding balance.
Choosing a loan with a good APR
To see how APR can affect business decisions, consider this example. Say you have two loans to choose from:
Suppose you picked the loan with the lowest interest rate—Loan B, at 6%. It may seem like a smart move, but thanks to the fees that get added on to the interest, you’re saddled with an APR of 10%. That’s an annual rate of 10% on the principal.
What if you pick Loan A? Sure, the 7% in total interest charges are higher than Loan B’s. But the APR is lower, at 9%—meaning there are fewer fees associated with the loan. All other things being equal, you’ll pay less over the life of the loan by picking Loan A—9% on the principal, compared to 10%.
A low APR means a lower cost of borrowing overall, and lower monthly payments.
Higher APR means more financial stress on your business—and a higher chance of missing payments and damaging your credit score.
Breaking down the APR calculation
You can also work backwards, using the amount of interest and fees you pay on a loan to determine its APR.
Here’s how you can calculate APR yourself:
Simple, right? Okay, maybe not. Let’s break it down with an example.
Say you’re taking out a loan of $3,000, with loan term of 180 days.
Over that 180 days until the due date, the total amount of interest you’ll pay is $250. On top of that, you’re charged a loan fee of $50.
In total, you’re paying $300 for both the interest rate and fees charged by the lender. Divide that amount by the loan amount—$3,000.
$300 / $3,000 = 0.1
Next, take that amount and divide it by 180 days.
0.1 / 180 = .00056
Since APR is based on a yearly rate, multiply that number by 365.
0.000056 x 365 = 0.204
Finally, multiply that by 100 to get a percentage.
0.204 x 100 = 20.4
So based on what you’re paying for your loan, the APR is 20.4%.
How can I estimate my APR’s impact on my daily/monthly finances?
If you want to see how the APR on a loan or credit card debt impacts your finances on a monthly or daily basis—called the monthly or daily periodic rate—you can do a little number crunching.
To calculate your monthly APR cost, use this formula:
((APR / 100) x Principle) / 12
Let’s say you have an APR of 14% on a $5,000 loan. You calculation would look like this:
((14 / 100) x 5,000) / 12 = 58.333
So in this case, the monthly cost of your APR would be $58.33. Keep in mind that you’ll be paying this monthly APR cost in addition to the percentage of the principle you’ve chosen to down each month.
(Also, in this example, we’re using simple interest. You can use this approach to get a rough estimate of what you’ll pay each month. But keep in mind that your monthly payments will become smaller as you pay down the principal.)
You can use a similar formula to calculate APR payments for different periods. Just substitute the divisor (12) in the formula above for biannual (2), quarterly (4), weekly (52), or daily (365) APR cost.
What types of fees are included in my APR?
The fees you pay will depend on the type of loan you’re taking out. For instance, a mortgage for commercial property will include, as part of its APR, property inspection fees. On the other hand, a business credit card will not.
But virtually every APR will include some of the following in its total cost:
- Underwriting fee: pays for the research to figure out if you’re eligible for a loan—reviewing and verifying financial statements, bank statements, tax returns, and your credit report.
- Document preparation fee: covers the cost of preparing paperwork related to your loan.
- Origination fee: A broad term that applies to any fees meant to cover the cost of approving and processing a loan application.
- Closing fee: covers closing costs associated with packaging your loan, carrying out business and real estate valuations, or costs associated with approving an auto loan
- SBA loan fee: paid by your lender to the SBA on all SBA loans, and passed on to you—ranges from 0.25% to 3.75%
Your loan may also include an application fee. This fee is non-refundable and you’ll pay it upfront—this means that you won’t get it back, even if your loan application is denied.
You’ve got protection: The Truth in Lending Act
Passed in 1969, the Truth in Lending Act (TILA) is meant to protect you from deceptive lending practices—including hidden or unnecessary fees charged by lenders or credit card issuers. According to the US Department of the Treasury, “It requires lenders to provide you with loan cost information so that you can comparison shop for certain types of loans.”
The TILA also regulates how lenders disclose fees and round numbers, and prevents them from using faulty calculation tools to calculate rates—among other things.
If you’re curious, you can check out a detailed breakdown of the TILA.
Fixed vs. variable APRs
There are two types of APRs: fixed rate and variable rate. It’s important to know which one you’re getting, because it will affect your monthly payments.
A fixed APR is based on a fixed percentage rate, determined by the lender. It doesn’t fluctuate based on any external factors. Every month, you pay the same amount of interest on your loan.
On the other hand, a variable rate APR is tied to an index. This means variable rates can fluctuate month to month. The most typical index for variable rate APRs is known as the prime rate.
What is the prime rate based on?
The prime rate is the minimum interest that banks charge when they lend money to businesses or individuals. Generally, the prime rate is about 3% higher than the federal rate.
Every six weeks, there’s a chance the prime rate will change. That’s because the Federal Open Market Committee of the Federal Reserve meets every six weeks to set it.
The prime rate can go up or down, but typically doesn’t undergo drastic changes. However, incremental changes over a longer period of time—say, five years—can mean that, by the time you’re almost done paying off your loan or paying down your credit card, you’re paying a significantly higher rate than when you were first approved. To get a sense of how often it changes, and by how much, check out the history of prime rates.
Planning to finance your business, but not sure where to start? Check out our quick and easy guide to getting a small business loan.