Interest rate and annual percentage rate (APR) are terms often used to mean the same thing, but they’re quite different. While a simple word exchange may sound harmless enough, the meanings are drastically different and can have huge implications. If you run a business and are considering financing now or in the future, it is a good idea for you to know what each term means and what makes them different.
In this guide:
- What is an interest rate?
- What is APR?
- How do I calculate my APR?
- Why is APR important?
- A (sometimes) fatal flaw with APR
What is an interest rate?
Interest rate is what a lender charges to borrow money – it is expressed as a percentage of the principal (i.e. the amount of money you have borrowed and have yet to pay back).
While interest rates are often presented as annual rates, that does not mean they are the same as APR, though it is easy to see how this might get confusing.
What is APR?
APR is a figure that tells you the true cost per year of borrowing money. How? Unlike the interest rate, APR factors in any additional fees and charges into the equation. As such, the APR is generally higher than the interest rate.
How do I calculate my APR?
Calculating APR often sounds more intimidating than it really is. In fact, most of the time your lender will provide you with the loan’s APR (and if they don’t, it’s probably a sign that there’s something fishy). However, if you are just given an interest rate (or an interest rate plus fees), it is helpful to know how to figure out this math.
There are many online loan calculators that can help you determine the true cost of a loan, but you can use this formula to determine the rate on your own. You will need to know your loan’s interest rate, the total amount you are borrowing, the total cost of – if any – fees, and what the repayment terms are.
You can find this using the following formula in an Excel spreadsheet:
=PMT(interest rate/months, the total number of months of your loan’s duration, the value of the loan [plus fees])
After determining your monthly payment in terms of dollars, you can use that number to figure out the monthly rate.
In another spreadsheet cell, use =RATE(total number of months of your loan’s duration, monthly payment as a negative, your loan’s current value)
You should get a decimal value.
Annual Rate – Decimal
Step three is easy: multiply the monthly rate decimal you got in the last step by 12.
APR (Annual Rate Percentage)
Now you take that decimal amount from step three and multiply it by 100 to determine the equivalent percentage value.
If you don’t have a spreadsheet handy, you can also find APR by dividing the total amount of your interest plus fees by the principal loan amount.
Then, take that number and divide it by the total number of days in the duration of the loan.
Why is APR important?
Now that you’ve done the work to understand APR, here’s why it’s so important.
APR is what allows you to understand the true cost of your loan. Since it includes all interest and fees, you get a clearer picture of all of the expenses associated with your loan and how much you’ll really pay.
APR is also one of the most useful metrics for comparing multiple forms of business funding. Depending on the options you’re considering, financing options may come with different fees and payment structures that would be otherwise hard to compare.
For example, one loan offer may have an attractively low-sounding interest rate, but if it’s compounded more frequently (daily as opposed to monthly) or comes with a collection of additional associated charges, it may be significantly more expensive than you initially thought.
APR is so important that most credit lenders are now legally required to disclose the rate to borrowers, thanks to the Truth in Lending Act, which was designed to protect consumers against inaccurate billing or credit practices that are unfair. While an interest rate will give you a quick version of what your loan will cost you, the APR accounts for more details.
A (sometimes) fatal flaw with APR
When shopping for a loan, many would-be borrowers compare APR numbers and simply choose the lowest one. “Lower is better” sounds like an easy assumption to make, but it’s not always true.
The loan with the lowest APR is not always the loan with the lowest actual long-term costs.
Why not? The lower-APR loan could actually be more expensive than a higher-APR loan, based on certain assumptions in the formula used to calculate it.
For example, consider the term length of the loan in question. APR assumes that you’ll pay off the loan over the full term, and not a year sooner. A 30-year mortgage, for example, sometimes comes loaded with fees up front, which the APR assumes will be spread over 30 years. If you were to pay it off sooner, your APR would go up, since you’d need to spread those initial costs over fewer years.
And what about those fees? APR calculations do account for certain fees or third-party costs associated with the loan, but some of those assumptions might not be correct if any of those fee amounts change. Additional fees may not all be accounted for in the APR calculation, making the APR lower and misstating the true all-in cost.
Finally, a single APR number isn’t very useful for projecting the costs of any adjustable-rate loan. Since the interest rate may change over the loan term, any APR number will change as well.
When comparing APRs and before choosing a financing option, try to keep these facts in mind. Calculate a few different scenarios to make sure that you’re making an informed choice.
Interest rate and APR are both important numbers to know and take into consideration when applying for any small business financing. Armed with the nuances around what each of them means, you should be able to more confidently choose the terms that are best for your business.
Disclaimer: Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. Please consult a tax professional for information about tax laws and how they apply to your business.