We understand that the search for a small business loan can be both frustrating and confusing. You’ve likely been inundated with lenders using terms like annual percentage rate, interest rate, and factor rate to explain why their loan product is better than the next. But the truth is, what’s best for one company may not be best for yours.
There are many different loans to choose from, but if you want to narrow down your options and compare the proverbial, apples to apples, you’ll have to know what each loan is actually going to cost you. In other words, you’ll want to know the bottom line or annual percentage rate (APR).
Annual Percentage Rate vs. Annual Interest Rate
While the interest rate does show how much you’re being charged on the money you borrow, it doesn’t include any other fees, and it may be expressed as a percentage for the life of the loan or some other term, rather than an annual rate. This is like comparing pounds to kilograms—two numbers can sound the same but actually represent very different figures.
Because the annual percentage rate (APR) represents a standardized term and includes all fees involved in the loan, it gives you a true understanding of what each loan will cost you over the course of a year. That’s why knowing a loan’s APR makes it so much easier to compare your options.
Knowing the True Cost of Your Small Business Loan
After you’ve narrowed down your loan options to the final two or three lenders, you’ll want to strongly compare and contrast your options to find the best fit. If you’re specifically looking for the cheapest loan, you may be tempted to choose the one offering you the lowest interest rate. After all, doesn’t a lower interest rate mean a cheaper loan?
Let’s say the two loans you’re comparing both charge an annual interest rate of 15%. We’ll call them Loan A and Loan B. If you base your comparison on annual interest rate, no matter which way you flip the coin, it appears that the cost of the two loans will be the same. After all, that’s all you can see.
What you’ve missed by just comparing the interest rate, however, is that the additional fees on Loan A add up to 2%, while added fees on Loan B account for up to an additional 4.5%. Depending on the size of your loan, that could easily be thousands of dollars in additional cost! This is something you can see when comparing the annual percentage rate instead.
Because the APR expresses the interest rate, the loan term, and other fees associated with the loan (such as origination fees and servicing fees), taking the time to calculate and compare a loan’s APR helps you to avoid spending more than you expect.
Calculating a Loan’s APR
Now that you understand the importance of knowing a loan’s APR, you’re ready for the next step—calculating it. The tricky part is, the way you calculate a loan’s APR depends on the loan offer you’ve received. There are a few things you’ll want to look out for:
- How long the term of the loan is
- How often payments are due
- If you’ll receive the entire amount of the loan
- What other fees are involved
- How the interest is calculated
Let’s take a merchant cash advance as an example. These lenders list their fees as a factor rate, meaning the interest is charged on the initial loan amount. If you compare that to an SBA loan, you’ll notice that the interest accrues on the principal as it’s being paid off. If you don’t understand the difference between the interest rate and factor rate, you may not understand what you’re really paying for a loan.
To make this process easier and be sure you’re doing calculations correctly, check out our various APR calculators for each loan product. Simply choose your loan product and input the basic details—our calculators will do the hard math for you!
When to Walk Away From a Loan or Negotiate
If you don’t have a great credit rating, revenue, or cash flow, you might not have lenders biting at the bit to offer you a loan. The ones that do make you an offer, however, may have an APR that you simply cannot afford.
Instead of struggling to make the payments, consider taking the time to strengthen your loan application. By making a few improvements and reapplying for a loan, you could improve your chances of qualifying for a loan with a lower APR.
On the opposite end of the spectrum, if you have a great credit rating, great revenue, and great cash flow, simply ask if the lender would be willing to lower the interest rate, or waive one of the fees attached to the loan. If a lender wants your business, they may be willing to meet your terms of agreement—especially if they know you have other offers on the table.
Remember, you’re looking for a loan to help your business—not hurt it. Always be sure to request or calculate the APR of a loan before committing to any agreements, and be sure that you are only committing to a loan that will be in the long term best interest of your business.