When business owners shop around for loans, the cost of the financing is almost always their primary concern—as it should be.
But too often, borrowers don’t pay attention to anything beyond the interest rate or APR quoted by the lender, and are surprised later when the payment structure makes their financing more expensive than they had expected.
Not having a complete understanding of loan interest can be very costly, and you owe it to yourself to be as educated as possible. Read through this guide, and you’ll be better equipped to find the best option when you’re borrowing money for your business.
What is an interest rate?
One of the most common borrower misconceptions is that “interest rate” and “APR” mean the same thing.
An interest rate (also known as a nominal interest rate) simply refers to the percentage that a lender charges annually for the financing they provide you. An interest rate is calculated by multiplying the loan’s periodic interest rate by the number of periods in a year in which the rate is applied.
However, an interest rate does not include closing fees or other transaction costs that the lender may charge you separately. As a result, an interest rate can give you a very incomplete picture of what a loan actually costs.
What is APR?
APR, or annual percentage rate, refers to the yearly cost of a loan including transaction fees, expressed as a percentage of the principal.
Let’s say a lender is offering a $20,000 working capital loan with a term of one year, in which 1% interest is applied every month, and the borrower must pay a 2.5% origination fee of $500 at closing.
The interest rate of the loan is 12% (1% periodic interest rate x 12 periods = 12%).
The APR of the loan is 14.5% (the original 12% rate plus the 2.5% fee = 14.5%).
Lenders often quote their loans in APR in order to give borrowers an easy-to-understand figure to use when comparing financing options. But that simplicity can be somewhat misleading because APR does not include the effects of compounding.
What is an effective interest rate?
An effective interest rate* reflects the true annual cost of funds on a loan when compound interest is taken into account. This is important because every time a periodic interest rate is applied, the total balance of what you owe changes—and the next periodic interest rate will be applied to that amount. You’re paying interest on the interest, in other words.
Granted, you’ll also be paying down a portion of your principal every month, so the total interest charges being added to your loan should be decreasing every period, not increasing. Nevertheless, knowing a loan’s effective interest rate in advance is important, especially because different loans compound on different schedules.
To calculate effective interest rate, use this formula: 1 + the periodic rate, to the [# of interest periods in a year] power, minus 1. Think about the $20,000 loan example we covered previously, with the monthly periodic interest rate of 1% (expressed below as 0.01). The calculation would be:
1 + 0.01 = 1.01
1.0112 ≈ 1.1268
1.1268 – 1 = .1268 = 12.68%
Add that to the 2.5% origination fee, and we get a total effective interest rate of 15.18%. A bit higher than 14.5%, right?
For the sake of argument, let’s see what happens if the interest on that loan was compounded weekly:
1 + 0.01 = 1.01
1.0152 ≈ 1.6777
1.6777 – 1 = .6777, or 67.77%
Add in the 2.5% origination fee, and we get a whopping 70.27% effective interest rate on the loan. Yikes!
The bottom line is that a loan’s APR doesn’t mean a whole lot if you don’t know how often the interest is compounded—and choosing a loan just because the rate is lower can wind up costing you thousands of dollars in additional interest. Borrower beware.
* Effective interest rate is essentially the same concept as APY (annual percentage yield), although that term is more commonly used in the context of interest-bearing investments, not loan products or debt financing.
What’s a factor rate?
For short-term business loans with terms less than one year, the concept of APR becomes even less relevant.
You can still calculate the hypothetical APR of a short-term loan by multiplying the periodic rate by the number of interest periods there would be over the course of a year—but that doesn’t reflect the reality of what you’ll actually pay for the loan.
To reduce confusion, alternative lenders often quote their financing products using factor rates. A factor rate shows how much a borrower will need to pay back to a lender, expressed as a decimal figure, regardless of the length of the loan.
For small business loans, a factor rate is the payback amount divided by the funded amount. For a merchant cash advance—in which a lender purchases a percentage of your business’s future receivables—it’s the purchased amount divided by the advanced amount.
So, let’s say you borrow $20,000 at a factor rate of 1.18. To calculate the cost of the funds, simply multiply $20,000 by 1.18 to get $23,600, which is the total amount you will owe the lender, not including transaction fees.
Although payment schedules for short-term loans can vary from daily to weekly to monthly, a factor rate already takes compounding interest and origination fees into account, thereby giving you an accurate sense of what you’ll end up paying the lender, when all is said and done.
What is amortization?
Like a car loan or mortgage, traditional small business loans (such as bank loans and SBA loans) rely on amortization, in which loan payments are spread out across a series of fixed payments, but the portion of each payment that goes toward your principal and toward your interest gradually shift over time.
In an amortized loan, interest costs are highest at the beginning of the loan—i.e., the interest is front-loaded—while your later payments mostly go towards paying off your principal.
If you’re looking for a detailed explanation of why lenders do this, Jack Guttentag of Mortgage Professor has an excellent breakdown here. Essentially, it’s an arrangement that allows lenders to provide borrowers with a predictable payment structure, even as their loan balance shrinks over time.
If you’re a homeowner, you probably already know that amortization can put you at a financial disadvantage since most people sell or refinance their homes long before their loan term is over—meaning that the majority of their mortgage payments go towards interest, not principal. (Refinancing a long-term business loan early in the term can be unwise for the same reason—all of your early payments go toward interest, and then you reset the clock when you start a new loan.)
But a short-term business loan doesn’t carry the same baggage since it’s not an asset you can sell before the term is over, and short-term loans often don’t follow an amortization schedule to begin with.
After all, short-term business loans exist to help business owners seize opportunities as they arise and the urgent need for capital usually comes with a large, rather immediate return.