APR stands for annual percentage rate. At the heart of it, APR is how much it costs you to borrow money.
Before you take out a loan or a line of credit for your business, you should have a firm grasp of APR and how it works. That way, you can compare rates and find the one best suited to your business.
APR vs. interest
While APR stands for annual percentage pate, your APR is different from the percentage rate (interest) a lender charges on your business loan.
The percentage rate is a percentage charged on the loan principal—the money you’ve borrowed. This percentage is only a part of your APR.The rest of the APR is made up of fees the lender charges when you take out your loan. Those fees get lumped together with the interest and you pay both down simultaneously, in installments.
Why does APR matter?
If you focus only on APR or only on interest when picking a loan, you could miss out on the chance to save money—or even end up paying more than you expected.
For instance, let’s say you have two loans to choose from:
Suppose you picked the loan with the lowest interest rate—Loan B, at 6%. It may seem like a smart move, but thanks to the fees that get added on to the interest, you’re saddled with an APR of 10%. That’s an annual rate of 10% on the principal.
What if you pick Loan A? Sure, the 7% interest rate is higher than Loan B’s. But the APR is lower, at 9%—meaning there are fewer fees associated with the loan. All other things being equal, you’ll pay less by picking Loan A—9% on the principal, compared to 10%.
That means a lower cost of borrowing overall, and lower monthly payments.
Breaking down the APR calculation
You can also work backwards, using the amount of interest and fees you pay on a loan to determine its APR.
Here’s how you can calculate APR yourself:
Simple, right? Okay, maybe not. Let’s break it down with an example.
Say you’re taking out a loan of $3,000, with loan term of 180 days.
Over that 180 days, the total amount of interest you’ll pay is $250. On top of that, you’re charged a loan fee of $50.
In total, you’re paying $300 for both the interest rate and fees charged by the lender. Divide that amount by the amount you’re borrowing, $3,000.
$300 / $3,000 = 0.1
Next, take that amount and divide it by 180 days.
0.1 / 180 = .00056
Since APR is based on a yearly rate, multiply that number by 365.
0.000056 x 365 = 0.204
Finally, multiply that by 100 to get a percentage.
0.204 x 100 = 20.4
So based on what you’re paying for your loan, the APR is 20.4%.
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How can I estimate my APR’s impact on my daily/monthly finances?
If you want to see how the APR on a loan impacts your finances on a monthly or daily basis, you can do a little number crunching.
To calculate your monthly APR cost, use this formula:
((APR / 100) x Principle) / 12
Let’s say you have an APR of 14% on a $5,000 loan. You calculation would look like this:
((14 / 100) x 5,000) / 12 = 58.333
So in this case, the monthly cost of your APR would be $58.33. Keep in mind that you’ll be paying this monthly APR cost in addition to the percentage of the principle you’ve chosen to down each month.
(Also, in this example, we’re using simple interest. You can use this approach to get a rough estimate of what you’ll pay each month. But keep in mind that your monthly payments will become smaller as you pay down the principal.)
You can use a similar formula to calculate APR payments for different periods. Just substitute the divisor (12) in the formula above for biannual (2), quarterly (4), weekly (52), or daily (365) APR cost.
What types of fees are included in my APR?
The fees you pay will depend on what type of loan you’re taking out. For instance, a mortgage for commercial property will include, as part of its APR, property inspection fees. On the other hand, a small line of credit to cover business expenses will not.
But virtually every APR will include some of the following:
Document preparation fee: covers the cost of preparing paperwork related to your loan.
Closing fee: covers costs associated with packaging your loan, or carrying out business and real estate valuations.
SBA loan fee: paid by your lender to the SBA on all SBA loans, and passed on to you—ranges from 0.25% to 3.75%
Your loan may also include an application fee. This fee is non-refundable and you’ll pay it upfront—this means that you won’t get it back, even if your loan application is denied.
You’ve got protection: The Truth in Lending Act
Passed in 1969, the Truth in Lending Act (TILA) is meant to protect you from deceptive lending practices—including hidden or unnecessary fees. According to the US Department of the Treasury, “It requires lenders to provide you with loan cost information so that you can comparison shop for certain types of loans.”
The TILA also regulates how lenders disclose fees and round numbers, and prevents them from using faulty calculation tools to calculate rates—among other things.
If you’re curious, you can check out a detailed breakdown of the TILA.
Fixed vs. variable APRs
There are two types of APRs: fixed rate and variable rate. It’s important to know which one you’re getting, because it will affect your monthly payments.
A fixed rate APR is based on a fixed percentage rate, determined by the lender. It doesn’t fluctuate based on any external factors. Every month, you pay the same amount of interest on your loan.
On the other hand, a variable rate APR is tied to an index. This means variable rates can fluctuate month to month. The most typical index for variable rate APRs is known as the prime rate.
What is the prime rate based on?
The prime rate is the minimum interest that banks charge when they lend money to businesses or individuals. Generally, the prime rate is about 3% higher than the federal rate.
Every six weeks, there’s a chance the prime rate will change. That’s because the Federal Open Market Committee of the Federal Reserve meets every six weeks to set it.
The prime rate can go up or down, but typically doesn’t undergo drastic changes. However, incremental changes over time—say, five years—can mean that, by the time you’re almost done paying off your loan, you’re paying a significantly higher rate than when you were first approved. To get a sense of how often it changes, and by how much, check out the history of prime rates.
Planning to finance your business, but not sure where to start? Check out our quick and easy guide to getting a small business loan.
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