Comparing APR, Interest Rate, and Total Dollar Cost

Comparing APR, Interest Rate, and Total Dollar Cost

Comparing APR, Interest Rate, and Total Dollar Cost

I’m convinced there are more small business loan options available today than ever before, but small business owners need to be more savvy as they explore their options and choose the financing that’s right for them. For example, comparing the costs of financing is more challenging today than it was when options were limited to traditional lenders like banks and credit unions. Understanding the differences between APR, interest rate, and total dollar cost will help you make apples to apples comparisons when evaluating any type of financing—whether it’s a term loan, a merchant cash advance, or invoice factoring.

There was a time when all you needed to know was the APR to make a comparison (today, some financing options like an MCA, don’t even express costs in an APR), but that isn’t the case any more. APR is a tool to compare similar loans with similar terms, but it doesn’t tell the whole story.

APR and Interest Rate

If you’ve ever purchased a new car or bought a home you’ve probably compared the APRs of at least a couple of lenders. APR is the annualized interest rate for the entire year including any fees. It’s not the same thing as an interest rate expressed monthly, weekly, or daily on a small business loan. If APR is the annualized rate, what is the interest being annualized?

If you think of interest as the cost of capital in terms of what a lender is charging at specific intervals, you can make a simple calculation to understand what the actual interest rate would be. At the risk of oversimplifying, the calculation looks like this:

APR/Payment Interval = Interest Rate

Let’s look at a couple of examples. Starting with a monthly payment interval with a 10% APR.

Let’s also look at that same 10% APR and look at a daily payment interval.

As the payment frequency increases, the interest charged per payment drops. As you can see, thinking about APR in relation to the number of payment intervals illustrates how when you’re comparing different loans, with different payment frequencies, or different loan types, APR doesn’t give you all the information and can even cause some confusion.

This is even more apparent when looking at short-term financing. For example, let’s compare a six-month term loan with a daily periodic payment with a six-month term loan with monthly payments:

Although the APR is the same in both of the above examples, the amount of interest the borrower pays with each payment is different. Because this makes it challenging to make an accurate comparison of the costs of different loan types, it’s important to understand total dollar cost.

Total Dollar Cost

The total dollar cost of a loan isn’t a difficult number to understand, but it might not be obvious without a little arithmetic. Subtract the principal amount from the total of all the payments (this will include all interest and any fees). The difference will be the total dollar cost.

As a general rule, shorter-term financing will come at a higher APR, but that doesn’t mean a higher overall dollar cost. Additionally, the shorter the term the higher the periodic payments will likely be, but the lower the total dollar cost could be.

With so many options available to small business owners today, without considering total dollar cost, it’s more difficult than ever to really evaluate one type of small business loan over another. The differences between short-term and long-term financing, factoring, merchant cash advance, and other types of financing designed for specific use cases, make it more important than ever to understand the cost of a loan.

Here are a few examples of what could be different for a $30,000 small business loan:

When total cost is considered, a loan that might not otherwise be considered could make sense depending on the loan purpose, or the reason a small business owner might be borrowing and makes it easier to compare one loan type to another. If you ask your lender to provide you with the total payback amount, this is a pretty easy comparison to make.

Why Does This Matter?

Most people wouldn’t even consider a 30-year auto loan regardless of how low the APR might be. That loan type just wouldn’t make sense to meet the loan purpose. The same is true for comparing loan purposes like purchasing quick-turnaround inventory, bridging a seasonal cash flow gap, purchasing a new warehouse, or building another location across town. There is no one-size-fits-all loan that would work equally well for buying inventory or building a new warehouse.

When most people think of a small business loan, they think of the traditional bank or SBA loan—which in many cases is the right choice. When comparing loans with similar terms and similar periodic payment frequency, APR is a reasonable way to compare. It might not be the best loan or the best way to compare when considering a longer-term loan and a shorter-term loan. This is particularly true when a defined ROI for the loan exists. In those cases, the business owner should be asking, “What is the total cost of the loan?” and “How much per dollar is this loan going to cost?” to make a more meaningful comparison. Make sure you compare APR, interest rate, and total dollar cost.

This article was originally written on August 12, 2020 and updated on August 14, 2020.

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ABOUT AUTHOR

Ty Kiisel

Ty Kiisel is a Main Street business advocate, author, and marketing veteran with over 30 years in the trenches writing about small business and small business financing. His mission at Nav is to make the maze of small business financing accessible by weaving personal experiences and other relevant anecdotes into a regular discussion of one of the biggest challenges facing small business owners today.

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