What’s the difference between interest rate and APR?

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Interest rate vs. APR: Key differences at a glance

To understand the differences between a loan’s interest rate and its APR, it’s important to take a look at the key features. Just note that every fee added pushes the APR above the interest rate.

What is an interest rate?

The interest rate is the percentage a lender charges you to borrow their money. If you borrow $10,000 at a 10% interest rate, you are paying 10% of that principal amount for the privilege of borrowing it, or $100.

However, be wary of how rates are quoted. Some online business lenders may quote monthly or weekly rates. A 10% monthly rate might seem low, but when annualized, it becomes significantly more expensive than a 10% annual rate. Your actual rate is determined by factors like your personal and business credit scores, time in business, annual revenue, and any collateral you provide.

Fixed vs. variable interest rates

• Fixed interest rates: These stay the same for the entire duration of your loan term, ensuring your payments remain predictable.
• Variable interest rates: These are tied to an index, such as the prime rate. If the index changes, your interest rate and monthly payments will change accordingly. Lines of credit and credit cards typically carry variable rates.

Simple vs. compound interest

• Simple interest: Calculated only on the principal amount borrowed. For example, on a $1,000 loan at 5% simple interest, you owe $50 in interest per year.
• Compound interest: Calculated on the principal amount plus any accumulated interest. This can significantly increase the total cost of your loan over time, as you are essentially paying "interest on interest."

What is APR?

APR is the standard measurement for the true cost of credit, and allows borrowers to easily make an apples-to-apples comparison between multiple loans. While the interest rate tells you what you pay for the principal, the APR serves as a standardized unit of measurement that rolls in other costs like origination fees, closing costs, and underwriting fees. Because two loans might have the same interest rate but very different fee structures, the APR is the superior measurement for making a direct comparison.

What fees are included in APR?

An APR usually includes various costs mandated by the lender to process your loan, but exactly which fees are included will vary by lender and loan type.

• Origination fees: Often 1%–8% of the loan amount.
• Underwriting fees: Charged to assess your creditworthiness.
• Closing costs: Administrative fees to finalize the loan.
• Broker fees: Costs paid to a third party for facilitating the loan.
• Points: Fees paid upfront on real estate loans to lower the interest rate.

How to calculate APR

To calculate the Annual Percentage Rate (APR) for a business loan, you must factor in both the interest rate and any additional lender fees. While the interest rate reflects the cost of borrowing the principal, the APR reflects the total cost of the loan over the course of a year.

In this simplified illustration, imagine you take out a $50,000 loan with a 10% interest rate and a $2,500 origination fee that is deducted upfront.

1. Calculate annual interest: At 10% on a $50,000 principal, you pay $5,000 in interest for the first year.
2. Factor in fees: You must also pay the $2,500 origination fee.
3. Determine total cost: Your total cost for the first year is the sum of the interest and the fees: $5,000 + $2,500 = $7,500.
4. Determine effective APR: You divide the total cost by the original loan amount: $7,500 / $50,000 = 0.15, or 15%.

In this scenario, even though your stated interest rate is 10%, your effective APR is 15%. Because the origination fee is a one-time cost, its impact on the APR will decrease the longer you hold the loan, but it remains a crucial figure for comparing different loan offers.

Rule of thumb: If a loan has no fees, the APR equals the interest rate. Every fee added pushes the APR above the interest rate.

Interest rate vs. APR by financing type

Business credit cards

For most business credit cards, the interest rate and APR are interchangeable terms. However, nearly all credit card APRs are variable. Keep in mind that different rates will typically apply to purchases, balance transfers and cash advances. And with nearly all credit cards, you can often avoid interest charges entirely by paying your statement balance in full and on time, each billing cycle.

Business term loans and SBA loans

This is where the difference between interest rate and APR is most pronounced due to origination, packaging, and guarantee fees. Bank loans and SBA loans generally have lower APRs, while online lenders often have higher rates and fees.

Business lines of credit

These often carry variable rates. With a business line of credit, you only pay interest on the amount you actually draw, but watch for maintenance and draw fees that can increase the effective APR above the stated rate.

When lenders don't quote an APR: Factor rates, monthly rates, and short-term loans

In many business financing scenarios, you won’t see an APR quoted on the offer. This is common with merchant cash advances (MCAs) and certain short-term online loans. Instead, these lenders may use alternative pricing methods that can make the cost of capital appear deceptively low.

Understanding factor rates

A factor rate is not an interest rate. It is a multiplier used to determine the total repayment amount. Unlike a traditional interest rate, which is applied to the declining principal balance over time, a factor rate is applied to the original funded amount.

• How it works: If you borrow $50,000 at a 1.4 factor rate, your total repayment is simply $50,000 × 1.4 = $70,000.
• The catch: You owe that $70,000 regardless of how quickly you pay it off. Because the cost is fixed at the outset, paying off the loan early—a strategy that usually saves money on interest-bearing loans—does not reduce the total cost of the financing.

Some online lenders quote their cost as a monthly or weekly percentage rate. While a 1% monthly rate might sound comparable to a standard annual interest rate, it is essentially a flat fee charged every month. If you pay a 1% monthly fee for 12 months, your cost of capital is significantly higher than a 12% annual interest rate because you’re paying that percentage on the original principal every month, rather than on a balance that decreases as you pay it down.

Converting these unconventional offers to an APR allows you to see the true interest rate, putting them on a level playing field with traditional financing. Often, you will find that a loan with a 1.2 factor rate or a 2% monthly rate carries an effective APR that is substantially higher — sometimes double or triple — what you might pay for a traditional bank term loan. 

Why business loans don't always show an APR

Unlike consumer loans, which are protected by the Truth in Lending Act (TILA), commercial financing is not always required to disclose an APR. This is why you might only see a monthly rate or a total payback amount on a business offer. However, at least eleven states now have commercial financing disclosure laws, with thresholds and coverage varying by state. 

If a lender doesn't provide an APR, ask them for one, or use a business loan calculator to find the effective rate yourself.

How to compare business financing offers

To quickly and accurately compare business financing offers, follow these steps:

1. Get every offer in APR terms: Ask the lender for the APR or use a calculator to normalize the costs.
2. Compare total dollar cost: Look at the total amount you will pay back, not just the interest rate or the monthly payment.
3. Request an itemized fee list: Ask about origination fees, closing costs, and prepayment penalties.
4. Weigh the trade-offs: Look at other factors such as a speed of funding  and qualification trade-offs. Also consider that a loan with a slightly higher interest rate but lower upfront fees may be cheaper than a low-rate loan with high hidden costs.

How to qualify for a lower interest rate and APR

There are steps you can start taking right now to ensure a lower interest rate and APR down the road – even if you’re not in the market for a loan at the moment. Using existing credit responsibly is the most important thing you can do. It’s also wise to:

• Improve your personal credit: Pay bills on time, lower your credit utilization and limit hard inquiries on both personal and business credit reports.
• Build business credit: Establish a solid history for your business entity.
• Improve financials: Maintain clean revenue documentation.
• Provide collateral: Offering assets can reduce lender risk and potentially lower your rate.
• Negotiate: If your credit score has improved since you first took out a loan, you can ask your current lender for a rate reduction.

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