By Carl Faulds
When you’re looking for a business loan, you naturally want to get the best deal possible. But with some lenders quoting APR and others a straightforward interest rate, it can sometimes feel like you’re comparing apples to oranges.
In this in-depth article, we’ll look at what the headline figures really mean—giving you the information you need to compare loans from different lenders so you can make an informed decision.
So, what’s an interest rate?
Interest rates affect every aspect of daily life. For example, when the Bank of England changes base rate, it automatically makes the evening news. If you get a letter in the post offering you a new credit card, there’s every chance it will have an interest-free period, quoted as 0%. Similarly, when you start looking around for a small business loan, you’ll encounter lots of different options with lots of different percentage rates.
Put simply, the interest rate is the percentage charged by a finance company for the privilege of borrowing their money—their profit, if you like. So if you borrow $50,000 over two years at an interest rate of 10%, with monthly payments and no arrangement fee, you’ll repay $2,307.25 a month, or a total of $55,374.00 over two years—that means interest of $5,374.00 on top of the capital you borrowed.
So, what’s an APR?
APR stands for Annual Percentage Rate, and it’s probably the most significant number you’ll encounter when seeking financing. Unlike a straightforward interest rate, an APR considers the full cost of taking out the loan, including arrangement fees and processing fees. If your lender won’t provide an APR, you should specifically request it, as it’s the most meaningful of all figures.
As an example, you might take out a $50,000 loan with a headline interest rate of 10% over a three-year term, with a 5% arrangement fee. The APR on this loan is 13.56%—a far cry from the 10% you were quoted. And where the APR differs from the simple interest rate, you may be certain that it will always be higher.
Comparing interest rates and APRs
Just to be confusing, some lenders usually quote a headline interest rate while others quote an APR. Let’s make some comparisons to show how wildly they can differ. Let’s say that Lender A offers you $50,000 over two years at an interest rate of 10% with an arrangement fee of 2%, and Lender B offers you the same $50,000 over the same two years at the same interest rate of 10%, but with an arrangement fee of 5%.
This is a no-brainer: Lender A has offered by far the better deal. When we translate these propositions, both with headline interest of 10%, into APR, Lender A is offering an APR of 14.05% (meaning you’ll repay $74,881.65 in total) while Lender B is offering an APR of 15.18% (meaning you’ll repay $78,739.10 in total). This is not a trivial difference, yet both loans have the same interest rate and Lender B’s offering seemingly attracts an arrangement fee that is only slightly higher.
Simple, isn’t it? Well, it is until we consider a third type of loan pricing: the factor rate.
RELATED: 10 Key Steps to Getting a Small Business Loan
What’s a factor rate?
To make life even more difficult, some business lenders don’t quote either a straightforward interest rate or an APR for their products. Instead, they price them using a factor rate (also known as a buy rate). The reason is that business loans are often structured quite differently from conventional bank loans.
A bank loan is an amortizing loan: that means that you make the same payment each and every month. This in turn means that with each payment you’re paying some proportion of the capital back and some proportion of the interest, but these proportions will change significantly over time.
For example, if you’re paying $2,500 in your first month, $1,700 of that might be principal and $800 might be interest. In the second month, your capital repayment might increase to $1,800 and your interest payment decreases to $700; in your third month, your capital payment might increase to $1,900 and your interest payment decreases to $600; and so on, until you’re paying nearly all capital.
However, with other types of financing such as short-term loans or merchant cash advances, the repayments are structured completely differently. Instead of charging interest on whatever capital remains at the time of each monthly payment, the lender charges all your interest upfront. This means that every payment you make will contain precisely the same proportion of capital and interest. It also means that there are no savings to be made in paying the loan off early, since you have already been charged the entire interest for the full loan term.
For this reason, finance companies might quote a factor rate of, say, 1.2 rather than an interest rate of 10% to indicate how expensive the loan is going to be.
How do factor rates work?
Put simply, a factor rate is a multiplier that enables you to calculate the total repayment you will make. In other words, if you borrow $50,000 at a factor rate of 1.2, your total repayment will be $60,000—the $50,000 capital plus $10,000 in interest. As we’ve just stated, this $10,000 interest will apply even if you repay the loan more quickly than agreed, which is certainly not the case with an amortizing loan product.
When you convert a factor rate into an APR, the cost may appear prohibitively high, but the total cost of repaying the money is usually far less alarming. So the big question you need to ask yourself is whether you want the flexibility to pay off the loan faster and save some interest or whether you’re more concerned with the likely total cost.
Let’s look at an example. Let’s say you want to borrow $50,000 to improve your cash flow and you’re offered a choice of three loans: a 1.2 factor rate, a 10% APR loan over five years, and a short-term loan with a seemingly horrifying interest rate (six-month term and 74.81% APR). How do these translate to actual repayments?
As we already know, the 1.2 factor rate will mean a total repayment of $60,000 and an interest charge of $10,000. With the 10% APR, five-year loan, there will be sixty monthly repayments of $1,062.35, meaning a total repayment of $63,741.13 and interest of $13,741.13. Meanwhile, the 74.81% APR loan over six months means six monthly payments of $10,243.06, totaling $61,458.37—meaning that the interest of $11,458.37 is actually lower than for the longer-term 10% APR loan. And, of course, the victor in this contest is actually the factor rate loan, with a total interest payment of just $10,000.
Don’t forget to consider the cost of your time
Interest rates—whether expressed as a headline rate, APR, or factor rate—are only part of the story. Never forget that time is money and that if one lender offers a marginally lower interest than another but has a far more onerous application process, you could do better to opt for the nominally more expensive loan and devote the time you save to building your business.
In particular, banks tend to demand huge amounts of paperwork before approving a loan—it’s not uncommon for them to request a detailed and fully costed business plan, your articles of incorporation, your balance sheet, profit and loss statements for three years, and tax returns for three years. They may even ask to examine the CVs of your senior management team. Collating this information can take a considerable amount of time, and given how cautious banks have become following the financial crash of 2008, you’re by no means guaranteed to get your loan.
In contrast, alternative lenders tend to have quite different acceptance criteria and generally are not concerned about examining large volumes of documentation. They also tend to be more flexible in regard to taking on borrowers with compromised credit histories—which raises another very important point.
You can help shape your interest rate
So far in this article, we’ve merely talked about comparing different types of interest rates. It’s also important to note that interest rates—however expressed—are not permanent and unchanging. In fact, they depend largely on your credit score, which in turn depends upon how your business has conducted itself from a financial standpoint.
In simple terms, your credit score results from an algorithm that takes complex financial information into a figure between 300 (very, very bad) and 850 (perfect). While each of the major credit bureaus uses a slightly different algorithm, and none of them choose to reveal their methodology, it is well known that there is plenty of common ground. Your payment history (whether you repay your borrowing on time and in full) is the most important factor, with other key criteria being the borrowing you have outstanding compared to your credit limits, the different types of borrowing you have (with some forms being considered riskier than others), and the amount of new credit you have taken out recently (as this can be a red flag that you’re experiencing financial problems).
If you want to improve your credit score and reduce the interest rates you are offered—whether headline rates, APRs, or factor rates—the easiest thing to do is pay down your credit card debts without closing any of your accounts. This is not a magic bullet and it won’t suddenly catapult your score into the 800’s, but even a small difference in your credit score can effect a change in the interest rates you are offered, which in turn can make a major difference in your payments, if you borrow enough.
RELATED: How to Get a Business Loan If You’re Credit’s Not So Hot
Finally, remember to compare different types of loans
The last thing to bear in mind is that secured and unsecured loans are very different beasts—the former is usually significantly cheaper, but that’s because it’s less risky for the lender and riskier for you. In simple terms, a secured loan involves collateral, which could mean business assets such as a factory or equipment—or it could mean personal assets such as your home.
If you fall behind on the payments of a secured loan, your lender can simply seize the security in lieu of the money. If you pledged a key business asset, your company could find itself in considerable trouble; if you pledged your home, the consequences speak for themselves.
In contrast, with an unsecured loan your lender would need to secure a court judgment against you before there was any chance of your assets being at risk. For this reason, the cheapest loan may not always be the best option—it’s a decision you will need to weigh carefully before you make a final decision.
Choosing the right loan
When you’re comparing offers from different lenders, here are the factors to bear in mind:
1. Don’t compare apples and oranges. Make sure you do the calculations (there are online tools to assist with this) so that you understand what you will actually pay back, irrespective of whether the lender is quoting an interest rate, an APR, or a factor rate.
2. Don’t forget that a short-term loan with a sky-high APR can actually cost you less than a long-term loan with a low APR.
3. Remember that with a factor rate, all the interest is charged upfront, so you won’t save a penny if your financial circumstances change and you’re able to repay the loan ahead of schedule.
4. Make sure you factor in the cost of your time. A slightly cheaper loan may not be the best bet if you have to jump through hoops to secure it.
5. Your credit score will affect all the interest rates you are quoted, and there are steps you can take to change it for the better.
6 Finally, don’t forget that secured and unsecured loans are not the same thing—are you more concerned about reducing your repayments or protecting your assets?
RELATED: Can Your Company Actually Afford a Small Business Loan?
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