When it comes to the world of small business financing, the number of acronyms that you will inevitably encounter can be overwhelming. ROI, DSCR, EBITDA…the list goes on.
However, there’s one 3-letter acronym that you’re likely familiar with. Taken out a student loan or a mortgage? Had your mailbox inundated with credit card offers touting an enticing “0% introductory rate”? Then APR probably at least vaguely rings a bell.
But, do you truly understand what APR is? How it works? Why it matters?
APR is important. Seriously. And especially when it comes to small business loans. In fact, having a firm grasp on what APR is and how to calculate it could save you hundreds or even thousands of dollars—and that’s no chump change.
Fear not. In this article, we’ll break down APR, and you’ll walk away with the ability to make more informed decisions about which type of financing is right for your business.
What is APR?
APR (or annual percentage rate) is the true cost of borrowing money per year, expressed as a percentage of the principal. It’s the true cost of borrowing money per year because, unlike the interest rate, APR also takes into account any additional small business loan fees that lenders may charge you.
Since APR not only factors in interest rate but also any extra fees or costs associated with your loan, the APR is almost always higher than the interest rate.
APR can either be fixed or variable. A fixed APR means that your APR will remain the same throughout the life of the loan. Fixed APRs are commonly associated with bank loans and business term loans from online lenders. On the other hand, a variable APR is generally based on a benchmark rate, like the prime rate, and can change over the life of the loan. You will most often find variable APRs associated with credit cards or a business line of credit.
How Do You Calculate APR?
To calculate APR, you’ll need the following information:
- The interest rate (and how often it compounds)
- Any fees associated with the loan (and how much each costs)
- The repayment term
- The total loan amount (the principal)
The easiest way to figure out your APR is to use an online calculator. But if DIY is more your thing, you can use an Excel spreadsheet to calculate it on your own.
We’ll be calculating APR using the following scenario: You borrow $40,000 with a 12% interest rate. The lender charges a 2% origination fee ($800). The loan is repaid monthly over a period of 24 months.
1. Determine the monthly payment on your loan by typing the PMT formula into any cell:
=PMT(rate, nper, pv)
- Rate = Interest rate (.12/12 = .01)
- Nper = Number of payments (24)
- Present value = Loan amount (40,000)
=PMT(.01, 24, 40,000) → -$1,882.94
Note: You need to divide the interest rate by 12 to reflect the payment period (i.e., monthly). If your payment period was bi-weekly, you would make 24 payments per year and would need to divide the interest rate by 24.
2. Determine the APR on your loan by using the RATE formula. Multiply the result by 12 to find the annual rate. Then, multiply it by 100 to get the APR, expressed as a percentage (rather than a decimal).
=RATE(nper, pmt, pv)*12
- Nper= Number of payments (24)
- Pmt= Monthly payment (-$1,882.94)
- Pv= The loan amount minus any fees ($40,000 – $800 = $39,200)
=RATE(24,=1882.94,39200)*12 → .0.1404508263*100 → 14.05%
Why Is APR Important?
The interest rate is the price a lender charges you to borrow money. But this figure does not give you the complete 411 of what a loan costs. That’s where APR comes in.
Since APR factors in the extra (sometimes sneak) costs that can be bundled into your loan terms, it is a more accurate representation of the price you’re paying to borrow money. APR is not only the best metric for evaluating the cost of a small business loan, but it also comes in handy when comparing borrowing options with different fee structures.
However, a lower APR may not always be “better.”
As an example, you can lower your APR by extending the term of your loan. However, loans with longer terms often come with higher interest rates. And while increasing the term of your loan will reduce your monthly payment amount and consequently your APR, you will have a greater number of payments, meaning you’ll end up paying more in interest.
It also might not make financial sense to choose a lower APR if that APR is quoted as variable. A variable rate can change significantly and could end up costing you substantially more.
While APR provides you with a good framework for evaluating a loan offer, you also need to understand all the other components of the loan to make the right decision for your business.