As a business owner, you’re probably used to making tough calls, like which products to stock and which employees to hire. But do you know how to choose a business loan? The wrong choice could cost your business a lot of money.
The key to choosing the right business loan is to understand APR or Annual Percentage Rate. At FitBiz Loans, we arrange many different types of business loans and believe APR is the best way to compare them all.
In this article, we’ll help you become a more informed business owner and borrower by explaining what APR is (hint: it’s not the same thing as interest rate), how it can be used to compare business loans, and when it might not be the best way to evaluate business loans.
APR vs. Interest Rate
There are 5 different ways to explain the cost of borrowing money:
- Nominal Interest Rate is the interest rate for the term of the loan. For example, a lender might say that the interest on a 6-month $10,000 loan is $500. In that case, the nominal interest rate is 5 %.
- Nominal APR takes the nominal interest rate and annualizes it. For example, the nominal APR on the $10,000 loan mentioned above is 10 % because you have to take the interest rate for the 6-month term (5 %) and double it to get the annual rate.
- Effective Interest Rate is an annualized rate that takes compounding into account. Compound interest is interest that is calculated on the initial principal of a loan and on interest that you’ve paid already. You can compare this to an interest-bearing savings account, in which interest is earned on interest. Loans work the same way, except that you pay the interest instead of earning it. Every time you make an installment payment on a loan, you are effectively borrowing less money but paying the same amount of interest.
- Effective APR (sometimes just called the Effective Annual Rate/EAR) is an annualized rate that takes both compounding and loan fees (e.g. application fee, origination fee, etc.) into account.
- Factor Rate – The factor rate tells you how much money you have to pay back in total to a lender. The factor rate on our example loan is 1.05 because $10,000 * 1.05 = $10,500 (the total amount that you have to pay back). In general, factor rate is not a good measure of cost because it wrongly assumes that you’ll pay back all interest and fees in one lump sum at the end of the loan. It doesn’t take compounding into account.
The average cost of a 6-month $21,000 term loan from a leading alternative lender is $3,780. Here is the cost breakdown for this loan:
- Nominal Interest Rate = 18 % (3,780 ÷ 21,000)
This is the stated interest rate given by the lender.
- Nominal APR = 36 % (18 x 2)
Take the nominal interest rate quoted for 6 months and double it to get nominal APR.
- Effective Interest Rate = 43 %
The formula for calculating effective interest rate is as follows:
EIR = (1 + nominal APR/no. of compounding periods)^no. of compounding periods – 1
In this case, 260 was the number of compounding periods because the lender charges interest every weekday.
- Effective APR = 79 %
The effective APR takes into account the lender’s origination fee along with compounding. I used the calculator from this article to get the effective APR.
- Factor Rate = 1.18
The factor rate on this loan is 1.18 because multiplying the principal ($21,000) times 1.18 gives you the total amount that you have to pay back to the lender ($24,780).
As you can see from this example, there is a huge difference between the interest rate provided by the lender and the effective APR! It’s important to know what type of interest rate you’re dealing with before choosing a business loan.
How To Evaluate & Compare Business Loans
In an ideal world, a lender would give you each of these five rates so that you can see how the length of a loan, compounding, and fees affect its cost and compare it to other loans. In most cases, however, you will only be told one or two measures of cost.
Unlike consumer lenders, business lenders are not required to disclose APR. Nonetheless, business lenders typically do disclose APR for bank loans and SBA loans. However, online lenders like OnDeck and Kabbage typically don’t disclose APR. Why? Because these lenders provide short term loans, which inflates APR and could scare away potential customers. In addition, many of their customers value speed and convenience over cost. As a result, lenders such as OnDeck and Kabbage normally quote a nominal interest rate or factor rate instead of an APR.
Here are some questions you should ask every business lender before committing to a loan. The answers to these will help you find out evaluate loan cost and compare loan products:
- What is the term of this loan?
- Is the rate you are quoting me the rate for the loan term or the rate for 1 year?
- How often is interest charged on this loan (i.e. compounding frequency)?
- Does the rate you are quoting me take compounding into account?
- What types of fees will I be charged for this loan?
- Does the rate you are quoting me take fees into account?
- How will my loan cost be affected by my credit history, the size and length of the loan, my business revenues, and other criteria used by the lender?
In addition to asking these questions, we have cost calculators for SBA loans and equipment leases (more coming soon) that you can use to help evaluate the cost of business financing and compare different loan products.
Should You Always Choose A Lower APR Loan Over A Higher APR Loan?
APR should not be your only consideration when shopping around for a business loan. To better understand why, here’s an example comparing a sample alternative loan from a leading online lender with a sample SBA loan:
from Online Lender
fee of 2.5 %
Packaging fee of 4 %
and closing costs of $23
Total Dollar Cost
of the Loan
For Every $1
As the table indicates, the SBA loan has a much lower APR but a much higher total dollar cost. The cost of the SBA loan is almost $5,000 higher, and you have to pay more than twice as much on the dollar for the SBA loan! Why? Because you are paying interest for 10 years on the SBA loan, versus just 6 months with the alternative loan.
For business owners that want to buy inventory, pay a vendor, or otherwise use cash in the short term, it may make more sense to get the alternative loan. Even though the APR is higher, you will end up paying a lot less money out of pocket.
On the other hand, borrowers who want to invest in their business long-term will do better to choose the SBA loan, despite the higher total dollar cost.
The SBA loan has a long 10-year term, so you have to pay only a small amount of the loan back with each installment ($251 every month). Consequently, you get access to the loan funds (plus the fees you eventually have to pay) for a longer period of time. You can use the money, for example, to remodel your store over several years or to hire a part-time employee, which may help you realize a nice return on your investment.
In contrast, if you take out the alternative loan, your installment payment is a lot larger ($192 every weekday) because you have to pay back the loan and fees in 6 months–a much shorter period of time. In other words, you get use of the capital for less time and may not be able to invest it in your business in a way that increases profits in the long haul.
When shopping around for a business loan, make sure that, at a minimum, you know the nominal interest rate and the effective APR. The nominal interest rate will help you compare the total dollar cost/payoff amount of different loans, which is an important indicator if you’re looking to borrow for a short period of time. The effective APR will help you compare loan costs in terms of compounding and fees, and this is important if you are looking to borrow over the long term.