When applying for a loan or any type of business financing, it’s essential for borrowers to understand the components that impact their repayment. Terms like interest rate and APR (annual percentage rate) are often used interchangeably, but they aren’t the same. Knowing the difference can help borrowers make more informed decisions when comparing loan offers.
What is an Interest Rate?
The interest rate is the cost of borrowing money, expressed as a percentage of the principal loan amount. When you borrow money, the lender charges interest as a fee for the use of their funds. Interest is typically calculated annually, although it may be compounded more frequently, such as monthly or daily, depending on the financing type. Lenders may charge you simple interest or compound interest based on the loan or financing you choose. While simple interest is a percentage of the principal, compound interest is calculated on the principal plus any accumulated interest.
When you borrow money, you’ll almost always pay interest on the sum you borrow. This applies to all sorts of loans, from business loans and lines of credit to mortgages and personal loans.
How do Interest Rates Work?
Interest rates are influenced by a variety of factors, including the level of risk associated with the loan, the current state of the economy, and the Federal Funds Rate. In general, interest rates tend to rise when the economy is growing and inflation is high, and they fall when the economy is slowing and inflation is low.
Borrowers don’t have control over these factors and their role in determining the interest rate a lender offers. However, lenders also consider your business finances when assessing creditworthiness, which can impact interest rates offered to you. Lenders typically evaluate your credit score (both personal and business) and revenue when determining the interest rate you’ll pay. Other factors, such as choosing a secured or unsecured loan, can impact on interest rates.
Interest rates tend to vary from one lender to the next, this is why it’s useful to compare rates and terms from different lenders before getting a business loan or credit card.
What is APR?
APR is the total cost of borrowing money for a given year not considering compound interest, expressed as an annual percentage. APR includes interest as well as other fees and charges associated with borrowing. While interest tells you the cost of borrowing, APR often gives you a more complete picture of the cumulative costs involved in taking out a business loan or line of credit. APR is never less than the interest rate, but APR and interest may be the same for lenders who don’t charge any fees in addition to interest.
All lenders are required to disclose the APR they charge borrowers. This is important for borrowers to note since APRs are almost always higher than interest rates, so many lenders use interest rates in advertising materials. As with interest, businesses with excellent credit and strong revenue can usually secure lower APRs.
Difference Between Interest Rate and APR
It’s important for borrowers to be familiar with both APR and interest rates when choosing a business loan or other financial product. But keep these important distinctions in mind when you’re reviewing these rates.
- Costs included: Your interest rate is the cost you pay for borrowing from a lender. On the other hand, APR includes not only the cost of borrowing, but also any other fees associated with the loan.
- Impact on monthly payments: Lower interest rates usually mean lower monthly payments on a loan. But the overall loan may still be expensive due to fees and charges you may not have considered. A low APR can indicate a cheaper loan even if monthly payments seem relatively high when compared to interest rates. Also, keep in mind that the annual percentage yield (APY) accounts for compound interest, a factor that APR does not account for.
- Role of credit: Great credit often means lower interest rates. However, even with a high credit score your APR may appear high as it includes fees and charges that aren’t typically impacted by your credit. Good credit may grant you a relatively lower APR compared to someone with a lower credit score, but a high APR may be a sign of large fees that inflate the overall cost of borrowing.
- Utility: Ultimately, the bottom line for borrowers is that interest is not as useful as APR as a measure of the cost of a loan. It’s a good idea to review APRs instead of interest rates when comparing different loans and their terms.
Keep in mind that not all forms of business financing have an APR, making it difficult to compare options. If you’re looking at a form of financing that doesn’t utilize APR, like revenue-based financing, it’s important to take all costs into consideration.
How are Interest Rates Calculated?
Simple interest and compound interest are calculated differently. Here’s how it’s calculated.
Simple interest is calculated using the formula: Simple Interest = P × r × t
Where P is the principal amount (the initial amount of money borrowed), r is the annual interest rate (expressed as a decimal value), and t is the time the money is borrowed for, in years.
For example, let’s say you borrow $10,000 at an annual interest rate of 5% for 3 years. Your principal (P) would be $10,000, your rate of interest (r) would be 0.05, and your loan time (t) is 3 years.
Using the simple interest formula of 10,000 × 0.05 × 3, you would pay $1,500 in interest.
Most credit cards and some lines of credit will charge compound interest instead. Here’s the formula that shows how it’s calculated:
Compound Interest = [P (1 + r)n] – P
Where P is the principal amount (the initial amount of money, r is the annual interest rate (as a decimal) and n is the loan period in years.
If you borrow $10,000 at an annual interest rate of 5% for 3 years, your principal (P) would be $10,000, rate of interest (r) would be 0.05 and loan term (n) would be 3 years.
CI = 10,000 × (1+0.05)3 − 10,000
CI =$1,576.25
You can see how compounding interest is higher than simple interest for the same amounts, interest rate and loan term.
How is APR Calculated?
APR is calculated by taking the total cost of borrowing money, including interest and fees, and expressing it as an annual percentage. To find your APR, you’ll need to know your periodic interest rate first.
Periodic Interest Rate = [(Interest amount + Total Fees) / Loan Principal] / Number of Days in Loan Term
Once you know your Periodic interest rate, multiply the figure by 365 and then by 100 to arrive at a percentage value. This formula requires you to know the interest you pay as a dollar amount, so you’ll need to calculate that beforehand using the formula for simple or compound interest (based on your loan).
Here’s an example. If you’ve borrowed $10,000 and expect to pay around $1500 in interest and $200 in fees over a loan period of a year (365 days), your equation will look like this:
Periodic Interest Rate = [(1500 + 200)/10,000]/365
Periodic Interest rate = 0.0004657
To arrive at your APR, multiply your periodic interest rate by 365 and then by 100 to get a percentage.
Annual Percentage Rate (APR) = (Periodic Interest Rate x 365 Days) x 100
APR = (0.0004657 x 365) x 100
APR = 16.99 which can be rounded off to 17%
By understanding how to calculate APRs and what they entail, you can make more informed decisions when comparing types of financing.
The Importance of Understanding APR
Understanding how APR works can be critical when comparing different business loans and lenders. While the interest rate is also important, APR presents the total cost of the loan minus compound interest each year. Always compare APRs on loans and lines of credit when shopping for business financing.
Interest Rate and APR FAQs
Which is more important, interest rate or APR?
APR is more important than the interest rate when you’re evaluating the total cost of your loan. That said, the interest rate provides useful information, too. A significant difference between APR and interest may indicate high fees associated with the loan. However, a high interest rate paired with proportionally high APR may be a sign that you’re not eligible for favorable rates.
Do you pay both APR and interest rate?
APR includes interest so borrowers do pay both. In practice, borrowers pay interest every month as they make payments on their loan, but they may pay additional fees at the time of taking on the loan.
Why is APR so much higher than the interest rate?
APR is often higher than the interest rate because it includes not only the cost of borrowing the principal amount but also any additional fees or charges associated with the loan, such as origination fees, closing costs, etc. However, when your loan carries no additional fees, your APR and interest may be the same.
