A quick guide to APR and interest rates

Comparing interest rates on credit cards or small business loans is prudent before taking on debt. Unfortunately, interest rates are often confused with annual percentage rates (APR). They are not the same. This article will explain how they differ and why it should matter to your business.

What is APR?

APR, which stands for “annual percentage rate,” is a number that represents the total cost of your debt. It’s expressed as a percentage of a loan or revolving business credit card balance and includes the interest rate, fees, and other charges associated with the debt. This concept was developed to help borrowers understand the cost of borrowing money. 

Like interest rates, APRs can be fixed or variable. A fixed APR stays constant throughout the life of the loan, while variable APRs fluctuate based on underlying index rates like the prime rate. Small business installment loans typically have a fixed APR. Business lines of credit and credit cards usually have a variable rate for revolving balances.

How is APR calculated?

Risk is the primary factor when setting an APR. Lenders look at your credit history, the term of the loan, the amount of the debt, and any fees associated with it. Borrowers with a higher risk of default are charged higher interest rates and fees. Those numbers are then plugged into an equation to calculate the APR. Here’s what that looks like:

APR = ((Interest + Fees / Loan amount) / Number of days in loan term)) x 365 x 100

For example, if you borrow $10,000 with $500 in fees and $1,000 in interest over a 365-day term, your APR would be approximately 15%. That’s the number to use when comparing different loan and credit card offers because it represents the total cost of the loan.

APR vs. interest rate

Interest can be an asset or a liability, depending on whether you’re the lender or the borrower. APR is a term used to represent a cost. Earnings on investments are expressed as APY, which stands for annual percentage yield. These terms are not interchangeable and should never be confused with one another. The only similarity is that both can be compounded. 

APRs are calculated by the lender. Interest rates are set based on indexes like the prime rate, so the lender has little control over them. Many lenders pin their rates to the index. An example would be charging 1% over prime, regardless of what prime is at that point. Variable interest loans and business lines of credit agreements are often constructed like this.

Why are APRs higher for business loans than personal loans?

Business loan APRs typically exceed those of personal loans for several reasons. To begin with, defaulting on a business debt simply creates a liability on the balance sheet. Defaulting on a personal loan affects your credit score and ability to get future credit. Those are the intangible reasons for higher APRs. The tangible reasons include the following:

• Shorter loan terms: Business loan terms are typically shorter than personal loan terms. This compresses the interest payments and fees into a shorter time frame, so the APR is naturally going to be higher.    
• Risk: There’s no such thing as a “sure thing” in the business world, especially in the volatile economic climate we’re currently living in. Lenders are aware of these market uncertainties and adjust their APRs accordingly.  
• Market conditions: Lenders raise rates during uncertain times to compensate for increased default risk. The Federal Reserve Bank also responds to market uncertainty by either raising or lowering interest rates.

What is a good APR for a business loan or credit card?

The industry consensus is that a “good” loan APR is anywhere from 7% to 30%. SBA loans and traditional bank financing for low-risk businesses are at the lower end of the scale. APRs for alternative loans and merchant cash advances are higher, sometimes exceeding 50%. That doesn’t make them a bad deal, but they are significantly more expensive.

Questions to ask when searching for a lender usually start with the rate, but there are other factors to consider. Are the terms and conditions clear and easy to understand? Can you find a similar loan with lower fees? How fast can you get access to the money? The answers to these questions could offset what you might otherwise consider a “bad” APR.        

Types of credit card APRs

Monthly credit card bills can be confusing. Just when you think you have them figured out, they change again. That’s mainly due to variable interest rates and the APR category assigned to the transaction. There are several of these, including the following:. 

• Purchase APR: The standard annual percentage rate you see highlighted on your credit card statement is called the purchase APR. It’s applied to everyday purchases when you carry a balance from month to month. It typically ranges from 15% to 25%. 
• Balance transfer APR: Moving debt from one account to another can save you money if you take advantage of an introductory “balance transfer” APR. These are usually offered by competing credit card companies to get you to switch providers.  
• Cash advance APR: The APR on cash advances starts accruing immediately after you withdraw the funds. That can make it a pricey way to acquire funding for your small business. A business loan or line of credit could be more cost-effective. 
• Promotional APR: A promotional APR is a temporary reduction for a defined period. An example is offering 6% for the first six to 18 months. This tactic can be used to entice new customers before reverting them to the standard rates.   
• Penalty APR: This is the highest APR category, often exceeding 29%. It’s triggered by late payments or violations of the cardholder agreement.

How to qualify for a lower APR

Knowing how APRs work is the first step toward qualifying for lower rates. Personal credit scores are a factor, so improving yours can help. Lowering your debt-to-income ratio is a good way to do that. From a business perspective, choosing the right type of loan for your business could also reduce your APR. An example is choosing a fixed-rate loan over a line of credit.

As you’re researching business loan, line of credit, and credit card rates, keep in mind that market conditions change frequently—and APRs will change with them.