APR vs. Interest Rate on a Business Loan: How to Find the True Total Cost

The interest rate tells you what the lender charges on the money you borrow. The APR, or annual percentage rate, tries to express the full yearly cost of the loan, including certain fees, as a single percentage that accounts for when you pay. When two offers have the same interest rate but different fees, or different repayment schedules, the APR is the better number to compare. For short loans with large fees, the gap between rate and APR can be dramatic.

What each number measures

• Interest rate. The percentage applied to your outstanding principal. It determines your monthly interest charge but ignores fees.
• APR. The interest rate plus the effect of upfront or recurring finance charges, annualized. In consumer lending, APR calculation and disclosure are governed by the Truth in Lending Act and Regulation Z, which also define which fees must be included.
• Effective rate or effective APR. A general term used by many business lenders for an annualized cost that may or may not follow the Regulation Z method.

An important point for business borrowers: the Truth in Lending Act mostly covers consumer credit, so many commercial loans are not subject to the same APR disclosure rules. A few states have filled the gap. California and New York, among others, require disclosures on certain commercial financing offers that include an estimated APR. That means a lender might quote a rate, a factor rate, or a flat fee, and you may need to calculate the APR yourself.

Worked example: same rate, different cost

The following is an illustrative example, not a quote. You borrow $50,000 for 12 months at a stated 8% interest rate and the lender charges a 3% origination fee, deducted from the proceeds.

1. Fee: 3% of $50,000 is $1,500. You receive $48,500 but owe $50,000.
2. Monthly payment: at 8% over 12 months on $50,000, the level payment is about $4,347.
3. Total interest: 12 x $4,347 is about $52,159, so interest is roughly $2,159.
4. Total cost of borrowing: $2,159 interest + $1,500 fee = about $3,659.
5. APR: you actually received $48,500 and repay $4,347 a month for 12 months. The annual rate that equates those two is about 13.6%.

So an "8% loan" has an APR near 13.6% because the fee is paid on a loan that lasts only a year. If the same fee were spread across a five-year loan, the APR would rise by far less, because the fee is amortized over many more months.

Why APR matters more for short loans

The shorter the loan, the more any fixed fee weighs on the annual cost. A $1,000 fee on a five-year loan is spread over 60 payments. On a six-month loan it is spread over six. That is why online short-term loans and advances can look cheap in dollars but expensive in APR. Our guide to factor rates and merchant cash advances shows how that plays out.

What can be left out of APR

APR is a helpful standard but not a perfect one. Check whether the quoted APR:

• Includes all origination and processing fees, or only some.
• Reflects the actual payment frequency. Daily and weekly payments pay principal down faster, which affects the true annual cost.
• Accounts for prepayment. If you repay early, a fixed fee is spread over fewer months, so your realized APR is higher.
• Includes costs outside the lender's control, such as appraisal, title or attorney fees, which may be charged by third parties.

Steps to compare offers properly

1. Ask each lender in writing for the amount funded, the total repayment amount, the payment schedule and every fee.
2. Ask for the APR, and ask which fees it includes.
3. If a lender gives only a factor rate or a flat fee, calculate the APR yourself using the total repayment, the net proceeds and the number of payments. The payment calculator on this site can help check the monthly payment and total, and you can compare costs side by side.
4. Compare the total dollar cost and the APR together. The APR shows efficiency, while the dollar cost shows the burden on your cash flow.
5. Re-run the comparison assuming you repay early, if early payoff is a realistic plan.

Common mistakes

• Choosing the lowest monthly payment without checking the term, since a long term can mask a high cost.
• Ignoring that fees are often deducted from proceeds, so you receive less than the stated loan amount while owing the full amount.
• Assuming advertised APR equals your APR. The advertised figure usually reflects the best-qualified borrowers.
• Forgetting variable rates. An APR on a variable loan is usually based on the rate on the day it was calculated and can change.

When to get help

If an offer is complicated, such as a loan with a balloon payment, a revenue-based repayment or mandatory add-on products, ask an accountant to calculate the effective cost. For disputes about disclosures or possible deceptive practices, you can contact the Consumer Financial Protection Bureau or your state attorney general.

FAQ

Is a lower APR always the better loan?

Usually, but not always. A lower APR on a loan that is larger or longer than you need can cost more in dollars. Compare both APR and total repayment, and make sure the loan size fits your purpose.

Does APR include the origination fee?

Typically yes, when APR is calculated under the Regulation Z method, but business lenders may follow their own methods. Ask which fees the APR includes.

Are business lenders required to disclose APR?

Federal Truth in Lending rules apply mainly to consumer credit. Some states, including California and New York, require certain disclosures for commercial financing. Check the rules in your state and ask the lender directly.

How do I calculate APR myself?

Find the rate that makes the present value of your payments equal the net amount you received. A spreadsheet's RATE function does this: use the number of payments, the payment amount and the net proceeds, then multiply the periodic rate by the number of periods per year.

Sources

• Consumer Financial Protection Bureau — Truth in Lending and Regulation Z information
• Federal Trade Commission — guidance on small business financing and deceptive practices
• U.S. Small Business Administration — loan program information
• California Department of Financial Protection and Innovation — commercial financing disclosure rules