In part two of our four-part series about small business interest rates, we looked at the difference between simple and compound interest. In this section, we’ll explore the difference between monthly interest rates and Annual Percentage Rate (APR).
When shopping around for a business loan, many borrowers make their comparisons based on interest rates. That number is important, of course, but it leaves out some factors that could end up costing you more than you anticipate over the long-term. To better understand how much money you’ll actually be required to pay over the lifetime of your loan, comparing the Annual Percentage Rate (APR) is a better bet.
A monthly interest rate is simply how much interest you would be charged in one month. This doesn’t include any other charges associated with the loan, and it doesn’t show exactly how expensive a loan actually is. APR, on the other hand, is the percentage rate charged on a loan over the term of one year. APR includes interest, plus fees and additional costs associated with your loan. The APR will always be higher than the interest rate, and it can vary greatly from lender to lender.
When lenders advertise only a monthly interest rate, it can be deceiving. For example, a 10% monthly interest rate adds up to an annual interest rate of 120%. When a business owner compares loans based on interest rates alone, he or she might see what looks like a lower rate—10%—and mistakenly think that this loan product offers a better deal than a loan that’s advertised at 12% APR. Thus, the easiest way to compare the prices of loans across different products and lenders is to look at the APR.
According to the Federal Truth in Lending Act, a lender must inform you of the APR on your loan. However, many lenders advertise a monthly (or weekly) interest rate as a marketing tool to attract borrowers, and the APR is in the fine print. By looking at an interest rate, rather than the APR, you’re left to guess about additional loan costs, which may include one-time charges like origination and application fees, or recurring fees like a monthly service charge. It’s important to know what’s included in the cost of your loan, and examining the APR is the best way to do that.
In addition to interest rates and fees, the APR of a loan can also be affected by the following:
- Loan term: Because APR is calculated based on a 12-month period, the length of time you have to pay it back will affect how much interest you will pay over the life of your loan.
- Payment schedule: How often you make payments will affect how much interest is applied for each one.
- Interest calculations: Does the interest rate decline as the balance is paid off, or remain flat?
- Collateral: Some banks keep a percentage of your loan in an account as collateral—similar to an escrow account—which borrowers can't access until the loan has been repaid.
If this all sounds overwhelming, it can be. That’s why there are great tools out there including NerdWallet's Business Loan Calculator. By simply plugging in a few key pieces of information, you’ll be able to calculate the APR for any loan and compare the APR for several different lenders and loan types.
As a borrower, it’s up to you to do your homework before securing a loan. Read all documents carefully before signing anything; ask any questions you have no matter how obvious they may seem, and remember: if an advertised interest rate sounds like it’s too good to be true, read the fine print.
Next up, read part four of our series about small business interest rates to learn about the different types of small business loans available to borrowers and how they compare.
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