As if applying for a small business loan wasn’t confusing enough, not understanding how interest is calculated can wind up costing you thousands more than anticipated. The devil’s always in the details.

First, let’s quickly define two business loan terms: interest rate and APR. Then we’ll look at two real-world examples to help you calculate the true cost of your next loan.

⇒ Interest Rate is what’s used to calculate your monthly payment. You only need this and two other pieces of data to determine your monthly loan payment:

• Amount borrowed, e.g. – \$100K

• Repayment Term, e.g. – 60 months

• Interest Rate, e.g. – 5%

With these three numbers you can use a loan payment calculator to calculate your monthly payment.

⇒ APR stands for Annual Percentage Rate. It is the true interest rate you pay.

This might sound confusing, so let’s look at a couple examples.

Example 1

Say you borrow \$100K with 5% interest and a repayment term of 5 years. Your monthly payment would be \$1,887.12. If there’s no other fees, the 5% interest will also be your true interest rate.

But often times, lenders have fees associated with a loan. For example, say that there’s a 3% loan origination fee charged up front (3% of \$100K is \$3,000), so the actual amount you get from the loan would be \$97,000 (\$100,000 – \$3,000).

Let’s say the lender also charges you a \$10 monthly loan servicing fee. Your monthly payments would actually be \$1,897.12 (\$1,887.12 + \$10).

To calculate your true interest rate, you take the \$97,000 you are borrowing and your \$1,897.12 monthly payments for the next 5 years. This comes out to 6.48% (the math is a little complex so we won’t go into it here, but it’s similar to calculating a mortgage loan). So your APR (true interest rate) is 6.48%, versus the advertised 5%.

A lot of lenders will advertise a low interest rate but charge exorbitant fees. Lenders are required to provide you with the APR when asked. As you can see, it’s a very important number to ask for because it is your true cost.

Example 2

Say you borrow \$10K at 5% interest with a 12-month term. See how the APR varies with different origination fees (with no monthly loan servicing charge):

• 1% origination => 6.88%

• 3% origination => 10.73%

• 5% origination => 14.69%

• 8% origination => 20.87%

Although the stated interest rate is 5%, with an origination fee of 8% your true interest rate (APR) is actually 20.87%. That’s because you are only getting \$9,200 up front, and paying back \$10,272.9 in total over the next 12 months.

As you can see, the APR can vary drastically from the stated interest rate, so make sure you understand your true cost before you take out a loan!

This article was originally written on September 17, 2014 and updated on October 17, 2019.