interest rates Archives

What is the Difference Between Interest Rate and APR?

by Brandon Wyson8 minutes / June 26, 2024

When applying for a loan or any type of business financing, it’s essential for borrowers to understand the components that impact their repayment. Terms like interest rate and APR (annual percentage rate) are often used interchangeably, but they aren’t the same. Knowing the difference can help borrowers make more informed decisions when comparing loan offers.

What is an Interest Rate?

The interest rate is the cost of borrowing money, expressed as a percentage of the principal loan amount. When you borrow money, the lender charges interest as a fee for the use of their funds. Interest is typically calculated annually, although it may be compounded more frequently, such as monthly or daily, depending on the financing type. Lenders may charge you simple interest or compound interest based on the loan or financing you choose. While simple interest is a percentage of the principal, compound interest is calculated on the principal plus any accumulated interest.

When you borrow money, you’ll almost always pay interest on the sum you borrow. This applies to all sorts of loans, from business loans and lines of credit to mortgages and personal loans.

How do Interest Rates Work?

Interest rates are influenced by a variety of factors, including the level of risk associated with the loan, the current state of the economy, and the Federal Funds Rate. In general, interest rates tend to rise when the economy is growing and inflation is high, and they fall when the economy is slowing and inflation is low.

Borrowers don’t have control over these factors and their role in determining the interest rate a lender offers. However, lenders also consider your business finances when assessing creditworthiness, which can impact interest rates offered to you. Lenders typically evaluate your credit score (both personal and business) and revenue when determining the interest rate you’ll pay. Other factors, such as choosing a secured or unsecured loan, can impact on interest rates.

Interest rates tend to vary from one lender to the next, this is why it’s useful to compare rates and terms from different lenders before getting a business loan or credit card.

What is APR?

APR is the total cost of borrowing money for a given year not considering compound interest, expressed as an annual percentage. APR includes interest as well as other fees and charges associated with borrowing. While interest tells you the cost of borrowing, APR often gives you a more complete picture of the cumulative costs involved in taking out a business loan or line of credit. APR is never less than the interest rate, but APR and interest may be the same for lenders who don’t charge any fees in addition to interest.

All lenders are required to disclose the APR they charge borrowers. This is important for borrowers to note since APRs are almost always higher than interest rates, so many lenders use interest rates in advertising materials. As with interest, businesses with excellent credit and strong revenue can usually secure lower APRs.

Difference Between Interest Rate and APR

It’s important for borrowers to be familiar with both APR and interest rates when choosing a business loan or other financial product. But keep these important distinctions in mind when you’re reviewing these rates.

Costs included: Your interest rate is the cost you pay for borrowing from a lender. On the other hand, APR includes not only the cost of borrowing, but also any other fees associated with the loan.
Impact on monthly payments: Lower interest rates usually mean lower monthly payments on a loan. But the overall loan may still be expensive due to fees and charges you may not have considered. A low APR can indicate a cheaper loan even if monthly payments seem relatively high when compared to interest rates. Also, keep in mind that the annual percentage yield (APY) accounts for compound interest, a factor that APR does not account for.
Role of credit: Great credit often means lower interest rates. However, even with a high credit score your APR may appear high as it includes fees and charges that aren’t typically impacted by your credit. Good credit may grant you a relatively lower APR compared to someone with a lower credit score, but a high APR may be a sign of large fees that inflate the overall cost of borrowing.
Utility: Ultimately, the bottom line for borrowers is that interest is not as useful as APR as a measure of the cost of a loan. It’s a good idea to review APRs instead of interest rates when comparing different loans and their terms.

Keep in mind that not all forms of business financing have an APR, making it difficult to compare options. If you’re looking at a form of financing that doesn’t utilize APR, like revenue-based financing, it’s important to take all costs into consideration.

How are Interest Rates Calculated?

Simple interest and compound interest are calculated differently. Here’s how it’s calculated.

Simple interest is calculated using the formula: Simple Interest = P × r × t

Where P is the principal amount (the initial amount of money borrowed), r is the annual interest rate (expressed as a decimal value), and t is the time the money is borrowed for, in years.

For example, let’s say you borrow $10,000 at an annual interest rate of 5% for 3 years. Your principal (P) would be $10,000, your rate of interest (r) would be 0.05, and your loan time (t) is 3 years.

Using the simple interest formula of 10,000 × 0.05 × 3, you would pay $1,500 in interest.

Most credit cards and some lines of credit will charge compound interest instead. Here’s the formula that shows how it’s calculated:

Compound Interest = [P (1 + r)n] – P

Where P is the principal amount (the initial amount of money, r is the annual interest rate (as a decimal) and n is the loan period in years.

If you borrow $10,000 at an annual interest rate of 5% for 3 years, your principal (P) would be $10,000, rate of interest (r) would be 0.05 and loan term (n) would be 3 years.

CI = 10,000 × (1+0.05)3 − 10,000

CI =$1,576.25

You can see how compounding interest is higher than simple interest for the same amounts, interest rate and loan term.

How is APR Calculated?

APR is calculated by taking the total cost of borrowing money, including interest and fees, and expressing it as an annual percentage. To find your APR, you’ll need to know your periodic interest rate first.

Periodic Interest Rate = [(Interest amount + Total Fees) / Loan Principal] / Number of Days in Loan Term

Once you know your Periodic interest rate, multiply the figure by 365 and then by 100 to arrive at a percentage value. This formula requires you to know the interest you pay as a dollar amount, so you’ll need to calculate that beforehand using the formula for simple or compound interest (based on your loan).

Here’s an example. If you’ve borrowed $10,000 and expect to pay around $1500 in interest and $200 in fees over a loan period of a year (365 days), your equation will look like this:

Periodic Interest Rate = [(1500 + 200)/10,000]/365

Periodic Interest rate = 0.0004657

To arrive at your APR, multiply your periodic interest rate by 365 and then by 100 to get a percentage.

Annual Percentage Rate (APR) = (Periodic Interest Rate x 365 Days) x 100

APR = (0.0004657 x 365) x 100

APR = 16.99 which can be rounded off to 17%

By understanding how to calculate APRs and what they entail, you can make more informed decisions when comparing types of financing.

The Importance of Understanding APR

Understanding how APR works can be critical when comparing different business loans and lenders. While the interest rate is also important, APR presents the total cost of the loan minus compound interest each year. Always compare APRs on loans and lines of credit when shopping for business financing.

Interest Rate and APR FAQs

Which is more important, interest rate or APR?

APR is more important than the interest rate when you’re evaluating the total cost of your loan. That said, the interest rate provides useful information, too. A significant difference between APR and interest may indicate high fees associated with the loan. However, a high interest rate paired with proportionally high APR may be a sign that you’re not eligible for favorable rates.

Do you pay both APR and interest rate?

APR includes interest so borrowers do pay both. In practice, borrowers pay interest every month as they make payments on their loan, but they may pay additional fees at the time of taking on the loan.

Why is APR so much higher than the interest rate?

APR is often higher than the interest rate because it includes not only the cost of borrowing the principal amount but also any additional fees or charges associated with the loan, such as origination fees, closing costs, etc. However, when your loan carries no additional fees, your APR and interest may be the same.

Brandon Wyson

Content Writer

Brandon Wyson is a professional writer, editor, and translator with more than nine years of experience across three continents. He became a full-time writer with Kapitus in 2021 after working as a local journalist for multiple publications in New York City and Boston. Before this, he worked as a translator for the Japanese entertainment industry. Today Brandon writes educational articles about small business interests.

That “Cheap” Business Finance Rate Could Cost You a Bundle: Interest and Your Business

Manage Your Money

by Wil Rivera4 minutes / July 17, 2018

That cheap business finance rate could cost you a bundle: interest and your business

The last decade has been an era of cheap money for businesses, with interest rates at historical lows. But those days may be ending. How you look at financing — in particular choosing between fixed and adjustable rates — may have to change.

These are the good old days.

Access to capital can often make or break a business. Each year, fifty-three percent of business owners kick in additional funding, according to the Small Business Administration. Almost a quarter add more than $50,000.

The adage that it takes money to make money is fine — if you have the cash on hand. If you don’t, it’s time to look at outside financing. But that may take some unlearning of recent lessons.

The global economic collapse beginning in 2008 was brutal, but it did have one benefit for some businesses: Because the U.S. Federal Reserve and other regulators slashed interest rates to stimulate buying, over the last decade the cost of money has been incredibly low.

Businesses who were approved for traditional forms of financing had enviable choices, including taking adjustable rates over fixed ones to keep borrowing costs down.

The Two Types of Interest Rates

A quick refresher: whether talking consumer or business financing, there are two general types of interest rates: fixed or variable.

A fixed rate is just that; the borrower pays a set interest percentage of the principal. Monthly payments don’t change.

Variable rates start at one rate. After some time, they shift to an amount based on any one of several common benchmark rates.

The Fed’s federal funds rate is one example of a benchmark rate. So is the prime rate, which is based on the federal funds rate, and is often what a bank’s best customers get. Another benchmark is the London Interbank Overnight Rate (Libor) — the rates banks charge one another on short-term borrowing.

The variable financing rate will be some number of percentage points over a benchmark rate. When the benchmark goes up, so will the variable rate. If the benchmark drops, the variable rate does as well.

Most people are familiar with variable rates from mortgages and credit cards. They are common in small business financing as well.

Variable Rates Have Been Low

In the past, business owners chose variable rates that were initially low. The idea was that when the rate increased, either revenues would have grown enough to more than offset it or refinancing at a lower rate would eliminate the extra costs.

For the last decade, however, variable rates have acted strangely. Because benchmarks were so low, you could effectively get a great rate for the life of the financing. There was always the gamble that the rate would climb, but in hindsight, for years you could win the game. Variable became almost the same as fixed.

No longer. By June 2018, the Fed had increased the federal funds rate seven times in three years.

As job growth remains brisk and the economy improves, regulators could keep increasing their rates, making all the benchmarks increase. Variable rates will follow, making the era of super-cheap money over. Opting for a variable rate instead of a fixed rate could now cost you.

Create a Financing Strategy

If you’re looking for financing, you’re best off doing some calculations in advance to see how a variable and a fixed rate might compare. Consider that a variable rate loan might increase a couple of times during the life of the financing:

Look at how much the Fed has raised the key interest rate over the previous 12 months and assume for a moment that the increases will continue in the near future, given how low rates have been.
Calculate the full principal, the length of the business loan, and the initial rate. Then use an amortization schedule to calculate how much you pay in the first year.
For the second year, calculate with an increased interest rate (initial rate plus the last 12-month increased in a benchmark) and the remaining financing time. Use an amortization schedule to calculate how much is paid in the second year.
Keep doing this for at least one or two more years with benchmark increases.
Finally, calculate the remaining principle, time left on financing, and the “final” interest rate. (Remember that this is an estimate and there might be additional rate increases.)
Add the payments over all the years and compare that to what you’d pay with available fixed rates.

You might choose to run estimates for different numbers and amounts of rate increases. This modeling can help you manage risk and choose an option that works for your business.

Wil Rivera

WD

Borrowing and Business: What You Don’t Know Can Hurt Your Finances

Manage Your Money

by Wil Rivera5 minutes / July 13, 2018

Borrowing and Business: What You Don't Know Can Hurt Your Finances

So, you’re feeling confident enough about your business to go shopping for a loan. Congratulations! But before you start looking you should understand these five important areas impacting loans, beginning with the difference between interest rates and APR.

What is APR?

APR is the annualized percentage rate, which measures the cost of borrowing money. It includes the total cost for the loan including covering all fees that the lender might charge.

By looking at the APR, you can objectively compare the costs of loans from different banks. That’s entirely different from looking at the headline interest rates that sometimes get advertised. Such headline rates frequently don’t include all the fees that you must pay to get the loan.

In short, if you looked only at the headline interest rates, then you might think you got a good deal when in reality you didn’t.

Always ask the loan officer for the APR in any loan. If they won’t provide it, then choose another bank.

LIBOR and interest rates.

The cost of a lot of business credit moves up and down in line with something called LIBOR, the London Interbank Offered Rate, which is an interest rate charged by banks to lend to other banks.

When the banks see little risk of lending to each other, then the LIBOR will be lower than it would be otherwise. When they see heightened risk of lending to each other, then the LIBOR typically rises as it did during the financial crisis.

Commercial businesses typically pay a fixed amount above the LIBOR for the duration of the business loan, see the Small Business Administration website for examples. The prime rate, which is a common benchmark lending rate for both commercial and consumer loans, is usually between 2.5 and 3.5 percentage points higher than the LIBOR rate, according to the FinAid website.

The LIBOR is also partly determined by decisions made by the Federal Reserve, which is a target interest rate for short-term overnight loans between banks. When that rate changes you can usually expect the LIBOR rate to change as well. In the simplest terms, if the Fed Funds rate rises then you should expect LIBOR to increase.

Recently, the Fed has been transparent about likely future changes in Fed Funds rates. If you regularly read the business press, you’ll be aware of most likely future changes in the costs of borrowing.

Fixed versus floating interest rates.

Not all business loans have interest rates which vary. Some have a fixed rate for the term of the loan. Such loans reduce the uncertainty about what would happen to the company’s profitability due to changes in short-term interest rates.

The cost of these loans is typically far higher than for variable rate loans. That’s because the bank takes on the risk of the interest rates changing over the term of the loan.

When a company purchases a long-lived asset, such as a factory building, it can make sense to seek out a fixed rate loan. That’s similar to seeking out a fixed rate home loan mortgage. Often, purchasing a building is a major expense and the predictability of the same monthly payment can help managers plan better for the future.

On the other hand, working capital typically gets funded through credit lines with variable rates of interest. That makes a lot of sense. When times are lean in business, then interest rates are lower and so are working capital needs. Conversely, when the economy is expanding, then although the cost of borrowing is usually higher, so is the demand for goods and services.

Sensitivity and the cost of borrowing.

Before you take out a loan, you need to understand what would happen to your profitability if the cost of borrowing increased.

For instance, if the cost of borrowing is $5,000 a month in interest and your company still would likely be profitable, then that is a good start. But then you also need to know if the business would remain in profit if the cost of borrowing increased. For instance, what would happen it the interest expense was half as much again, or $7,500 a month. Making theoretical changes and then calculating the likely outcomes is known assensitivity analysis. It is something that your Chief Financial Officer or accountant should be capable of doing.

If a change in interest rates of relatively small magnitude would vastly reduce profitability, then you might want to consider a smaller loan.

Likewise, when you conduct the interest rate sensitivity analysis, you may want to consider what would happen to the earnings if revenue fluctuated when the company also had a new loan. If even a small dip in sales would cause the company to lose money then perhaps it would make sense to be cautious by reducing the possible size of the loan.

Wall Street Prep has some useful tips on running sensitivity analysis.

Derivatives and interest rates.

Interest-rate derivatives exist to help companies guard against changes in the cost of borrowing. Rather like knives, when appropriately used, they can be a useful tool. However, when wielded incorrectly they can be harmful.

So-called interest rate swaps can be used to convert a variable rate loan to a fixed rate loan, and vice versa. These products can be useful, but the customers should have a high level of sophistication.

Unfortunately, in the United Kingdom, some banks inappropriately sold small businesses some of these products. That eventually led to losses by some buyers of these derivatives. Given that many of the people selling these swaps hold higher-level finance degrees it is frequently the case that the buyers are far less sophisticated than those selling the products.

Two things to take away from this episode. First, if you have any doubts that you truly understand the product then don’t buy it. Second, just because these problems occurred in the U.K. don’t think they couldn’t happen in the U.S.

Tag Archive for: interest rates

What is an Interest Rate?

How do Interest Rates Work?

What is APR?

Difference Between Interest Rate and APR

How are Interest Rates Calculated?

How is APR Calculated?

The Importance of Understanding APR

Interest Rate and APR FAQs

Which is more important, interest rate or APR?

Do you pay both APR and interest rate?

Why is APR so much higher than the interest rate?

Brandon Wyson

Content Writer

Related Posts

New SBA Financing Rule in Effect

What is an Unsecured Business Line of Credit?

Why Should Small Businesses File Taxes Early?

These are the good old days.

The Two Types of Interest Rates

Variable Rates Have Been Low

Create a Financing Strategy

Wil Rivera

WD

Related Posts

New SBA Financing Rule in Effect

What is an Unsecured Business Line of Credit?

Why Should Small Businesses File Taxes Early?

What is APR?

LIBOR and interest rates.

Fixed versus floating interest rates.

Sensitivity and the cost of borrowing.

Derivatives and interest rates.

Wil Rivera

WD

Related Posts

New SBA Financing Rule in Effect

What is an Unsecured Business Line of Credit?

Why Should Small Businesses File Taxes Early?