If you’re shopping for small business loans, you might become confused by all the terminology that gets thrown your way. With factor rates, profit and loss statements, 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 (APR) 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.
APR vs. Interest Rate: What’s the Difference?
Annual percentage rate and interest rate are two similar but ultimately different things. Let’s start with a definition for both.
APR stands for annual percentage rate.
In the United States, the disclosure and calculation of this rate are 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 borrowing money for a loan. 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. Closing fees, origination fees, documentation fees, and other finance charges are part of this rate.
There is also 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:
- Purchase APR: Purchase APR is the rate you will pay on credit card purchases that aren’t paid back by the end of your billing cycle.
- Balance Transfer APR: This APR applies to any balances that are transferred from one card to another. It is usually charged on the date you make the transfer.
- Introductory APR: This is typically a 0% rate that applies for a period of time immediately after opening a credit card account. The 0% rate allows you to carry a balance from month-to-month without incurring interest charges, as long as you make the minimum monthly payment. This makes introductory APR credit cards a good financing option for small businesses.
- Cash Advance APR: The cash advance APR is the rate you will be charged for withdrawing cash from your line of credit. It is typically higher than purchase or balance transfer APR.
- Penalty APR: This may be incurred if you miss a credit card payment. Along with having a higher rate, you may also do damage to your credit score.
So, with APR vs. interest rate, your interest rate shows the base cost of borrowing money, while 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, per the Wall Street Journal.
Interest Rate Definition
Your interest rate is the cost you to borrow money. This is not to be confused with simple interest rate, which is a fixed percentage of the principal amount borrowed and doesn’t include additional fees. 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.
Interest rates can either be variable or non-variable, 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 change 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, so does your interest rate and APR.
How Can I Calculate Interest to APR?
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 APR 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:
- The interest rate of the loan
- The total amount you plan to borrow
- The repayment terms
- The cost of any fees
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 two-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.
Step 1: 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.
Step 2: Once you’ve 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.
Step 3: Multiply your monthly rate (0.0141) by 12 to get an annual rate.
0.0141 x 12 = 0.1692
Your annual rate—not expressed in percentage form—is 0.1692.
Step 4: Multiply by 100 to convert from a decimal into a percentage.
0.1692 x 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.
The Bottom Line
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. 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.
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). The takeaway is this: If you want to compare apples to apples for business loans, then you need to know each loan’s APR.
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.