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If you’re looking at business loan options you’re probably asking yourself, “What is APR?” Getting a business loan is a common decision for business owners to make; however, with loans, comes interest and fees. However, you’re not alone when it comes to curiosity about your annual percentage rate (APR) as roughly 80% of US businesses rely on some form of credit. Whether you need to improve your cash flow for a few months or are looking to expand your business, having access to capital is what makes it happen. But next comes the process of how to calculate your APR.
Determining how to get a business loan can be overwhelming in itself. There are various loan options, numerous sales pitches, and tricky verbiage used in these deals. How do you know what’s best for your business? Cutting through all this chaos, you should focus on the annual percentage rate. Learn to calculate APR on the business loan options you are looking at will provide your answer. In this article, we will go over everything you need to know about your loan’s annual percentage rate.
What is APR?
The annual percentage rate–or the APR–is a calculation that tells you how much it actually costs to borrow money each year. When you use the APR formula, it takes add-on fees and charges into account. These hidden costs are often in the fine print of the loan agreement.
The APR is the true cost of a business loan. If you get a quote for the interest rate, remember this percentage does not include these fees. So make sure that you ask about the annual percentage rate. When you’re comparing various loan offers, this is your magic number.
It should be noted that an annual percentage rate applies to most forms of credit but for the purpose of this article we will be solely applying it to business loans.
How APR Works
When you get a business loan, there are usually additional costs to getting that loan. Some of the common fees for business loans include:
- Application fee: This is a charge for processing your loan application
- Closing costs: Similar to personal mortgage loans, you may have closing costs for commercial mortgages or other types of commercial real estate loans
- Annual fee: If you get a business line of credit, you might be charged an annual fee
All of the fees and the interest rate charged on your loan factor into your APR. The lower your annual percentage rate, the more favorable the loan terms are for your business. We’ll go over how to calculate APR shortly.
Why is Your Annual Percentage Rate Important?
When you’re shopping around for loans, you won’t get the full picture of how much the loan costs if you’re just looking at interest rates. A very low-interest rate on a loan may catch your eye at first. But if the interest compounds daily or has several associated fees, the loan ends up being more expensive than other options. Looking at the annual percentage rate provides an “apples-to-apples” comparison. This is precisely why you need to factor in the specific type of loan you’re applying for as well as the type of APR it falls under.
Types of APR
When shopping for business loans, you’ll come across two different types of APR: fixed and variable. In addition, you can opt for a merchant cash advance. If you choose one type over another, there are implications to be aware of. Knowing which type of annual percentage rate you have will determine how you can calculate APR for your specific loan.
When a loan has a fixed APR, that means the annual percentage rate will stay the same for the entire life of the loan. Your monthly costs will not fluctuate, so you pay back the same amount each month. This is ideal if you’re looking for a fixed-cost solution without any surprises.
Unlike fixed APR, if your business loan has a variable rate, your cost could go up or down. Unfortunately, this is often at the lender’s discretion. Typically these rates are tied to another interest rate such as the prime rate. This is the rate at which banks lend to each other. You could end up more or less than you originally started out with if you choose a variable rate.
Another business financing option for small businesses is the merchant cash advance. The concept is rather simple. You get your cash upfront in exchange for a percentage of your credit card sales. The APR you end up paying depends on the retrieval rate the lender sets and your factor rate.
For example, if you take out a $10,000 cash advance and your lender sets your retrieval rate at 10% of your daily revenue. You have a 1.5-factor rate which means you’ll actually be paying $15,000. Your effective APR would be 106.10% and take ten months to repay.
APR Formula: How to Caclulate APR
Your lender controls the factors that go into your annual percentage rate since they control the charges and fees. To calculate APR:
- Add all your fees/charges and the total interest paid over the course of the loan
- Divide by the amount of the loan
- Divide this number by the total number of days in the term
- Multiply by 365, this is your annual rate
- Multiply by 100 to convert the annual rate into a percentage
The Factors that Affect Your APR
The interest rate makes up the vast majority of your annual percentage yield. These interest rates will vary tremendously but the factors that tend to affect it the most are:
- Your personal credit score: A lender will look at your business and how creditworthy you are as an individual.
- Type of loan: The type of business loan that you get will have an effect on the interest rate you receive; bank loans are usually between 5-15%, while alternative lenders tend to have higher rates.
- National interest rates: The Federal Reserve sets the national interest rates, which also determines the interest rate you may get on a loan.
- Business history: If you’re a new business or startup, your interest rate is typically higher. This is because lenders see your business as a higher risk than more established ones.
- Financials: Having a strong balance sheet with steady and reliable cash flow will make it more likely for a lender to offer a lower interest rate
- Collateral: If you put up any collateral for the loan such as business equipment, real estate, inventory, etc., you could get a lower rate.
APR vs. APY
Another way to calculate loans is by using the Annual Percentage Yield (APY). As discussed, your APR is your yearly rate, but it doesn’t take your compound interest into account. APY is your effective annual rate and it includes how often the lender applies interest to your balance. Investments like savings accounts use this calculation.
APR vs. EAR
Your EAR, or Effective Annual Rate, takes into account the effects of compounding interest. The interest on your loan may compound daily, monthly, quarterly, or yearly. That interest earned is added to the principal balance. Then that interest accrues interest, which is called compounding interest. APY may be higher than your APR if your interest compounds more often than once a year.