And Why it Matters for Your Small Business
By Meredith Wood of Fundera
Being a small business owner comes with a lot of hats. As you well know, you can often serve as the HR manager, the accountant, maybe even the janitor. All of this in addition to creating a fantastic product or service for your customers.
That’s why it’s crucial you continually search for products to make your life easier (e.g. a solution that helps automate the payroll process) and educate yourself on areas you aren’t as familiar with.
For those who don’t come from a strong finance background, obtaining financing can be an intimidating part of running your business. Borrowing capital comes with its own set of rules, standards, and terminology—and the cost to business owners of not understanding this vernacular can be substantial.
One distinction that we find to be routinely confusing for small business is the difference between APR and your loan’s interest rate. Let’s break down what these terms mean and how they impact your business:
What is an interest rate?
As a basic definition, a loan’s interest rate is the proportion of the loan that is charged to the borrower, expressed as a percentage. But in practice, the interest rate on a line of credit is a vague term that can mean different things depending on the particular stipulations of the loan. There are simple interest rates, compound interest rates, flat interest rates, and more. For small business owners looking to take out a short term line of credit, the most important distinction is between the loan’s interest rate and APR.
What is APR?
If you’ve ever bought a car, taken out a student loan, or applied for a mortgage on a house, APR is probably the terminology for a loan’s interest rate that you’re familiar with. Essentially, the APR or annual percentage rate of a loan is the annual cost that is charged to the borrower for the length (or term) of the loan, expressed as a percentage rate. On longer term loans, the APR typically, but not always, includes any fees or other costs associated with the transaction.
Why does it matter?
When you take out a long term loan (i.e. any line of credit with a borrowing period of more than a year) the difference between the loan’s APR and interest rate can be negligible or even non-existent. In fact, for many longer term loans, the APR is the only interest rate calculation ever expressed.
But when a borrower takes on a line of credit for a shorter period—such as with a Merchant Cash Advance or alternative line of credit—this small change in terminology becomes much more than just semantics. Because the given interest rate is expressed in the scale of the borrowing period, a seemingly reasonable interest rate on a short term loan can quickly double or triple—or even more—when expressed in terms of APR!
How do I calculate the difference?
A 10% interest rate on a 6 month loan may sound more expensive than a 5% interest rate for just one month, but that’s not necessarily the case. That’s why, when comparing the terms and interest rates of various short term loans, it’s important to make sure you’re comparing apples to apples. The best way to do this is to re-calculate the interest rate into what’s called the loan’s effective APR. Essentially, the question you’re asking when calculating a loan’s effective APR is this: if the borrowing period for each of these loans were one year, what would the respective interest rate for the year be? The formula is fairly simple:
APR = i x n
Where i = interest rate (expressed as a decimal)
and n = number of periods per year
So let’s compare those two rates above in terms of their effective APR.
Loan A: 10% interest rate on a 6 month loan
i = 0.10
n = 12 / 6 = 2
APR for Loan A = 0.10 x 2 = 0.20 or 20%
Loan B: 5% interest rate on a 1 month loan
i = 0.05
n = 12 / 1 = 12
APR for Loan B = 0.05 x 12 = 0.60 or 60%
Yes, you read that correctly. That friendly little 5% interest rate, when calculated in terms of effective APR, suddenly jumped to sixty percent! That means not only would you be required to pay back Loan B much sooner (in just one month compared to six), but the effective annual rate of interest would be three times that of Loan A! Now which of these is looking like the better deal?
And with typical interest rates for alternative loans reaching as high as 50%, these numbers can become even more daunting. Not to mention that not all alternative loans include additional brokerage costs and fees within the given interest rate. That’s why for those that qualify, an FDIC insured, regulated bank loan is almost always the best bet.
But if your credit isn’t great or your business needs quick access to capital, a traditional bank loan isn’t always an option. If you find yourself in the market for an alternative loan for your business, be sure to do your homework. Ask questions about additional fees, and be sure you’re comparing interest rates in terms of effective APR. That way, you can feel confident in choosing the best available option for your business’ bottom line.
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more. Meredith is also the Senior Financial and B2B Correspondent for AlleyWire.