What it means
When a lender advertises a loan at 6% interest, that is not necessarily what you will pay. Arrangement fees, processing charges and other mandatory costs add to the burden, and the APR rolls them into one yearly figure.
A loan with a lower interest rate but high fees can end up costing more than one with a slightly higher rate and no fees. APR is most commonly used for consumer products such as credit cards, car finance and mortgages, but business owners meet it too.
Equipment finance, merchant cash advances and invoice finance are often quoted with rates or factor fees, and converting these to an APR shows what the borrowing truly costs over a year. The calculation differs from country to country, and lenders are usually required by regulation to disclose it in a standard way.
This means the exact fees included can vary, so it is worth reading the small print to see what is and is not counted. Late payment fees and optional insurance are commonly excluded.
APR should not be confused with APY, the annual percentage yield, which includes the effect of compounding (interest earning interest). APR on a credit card is usually quoted without compounding, even though interest is charged daily or monthly.
A card with a 24% APR therefore costs more than 24% over a year if the balance is left unpaid. APR is also not a forecast.
For a variable-rate loan it reflects the rate at the time of quoting, and it assumes you hold the loan for its full term. If you repay early or the rate changes, the true cost will differ.
For a business borrower, the practical habit is to ask every lender for the APR in writing and to request a full list of the fees included. Where the APR is not offered, such as with some alternative finance products, you can calculate it yourself with the formula below.
Doing this before signing takes only a few minutes and can save a substantial amount of money.
In practice
Real-world examples
Example 1
A small bakery compares two $25,000 equipment loans, each repaid in full after one year. Lender A offers 5.5% interest with a $1,500 arrangement fee, and Lender B offers 6.5% with no fee. By converting both to APR, the owner finds that Lender B is cheaper over the full term.
Example 2
A consumer sees a credit card advertised at 0% interest for six months and a standard APR afterwards. The marketing manager of the card issuer must show the standard APR prominently, so customers understand the cost once the offer ends.
Example 3
A freelance designer takes a cash advance of $20,000 and agrees to repay $22,400 over 12 months. Dividing the $2,400 cost by the amount advanced gives 12%, but because she repays in instalments the effective annual cost is higher, which APR rules help reveal. She asks the provider to show the fee schedule in writing so she can confirm the figure.
Think of it
Think of the APR like the ticket price for a flight. The basic fare is the interest rate, but baggage fees and seat selection charges are the loan fees. The final total price is the APR, showing you what the trip truly costs.
Formula
Calculation
APR = ((Total interest + Total fees) / Principal) / Number of days in loan term x 365 x 100
Suppose a business borrows $10,000 for 2 years (730 days). Total interest over the term is $1,200 and the lender charges fees of $200. Step 1: add interest and fees, 1,200 + 200 = $1,400. Step 2: divide by the principal, 1,400 / 10,000 = 0.14. Step 3: divide by the days, 0.14 / 730 = 0.00019178. Step 4: multiply by 365, then by 100, 0.00019178 x 365 x 100 = 7%. The APR is 7% even though the interest alone is only 6% a year.Case study
Seen in the real world
Maplewood Trading is an illustrative, fictional wholesaler that needed $150,000 to buy seasonal stock. Its finance manager received two offers: a bank loan at 7% interest with a $4,500 fee, and a supplier credit line at 9% with no fee.
The manager first assumed the bank loan was cheaper because 7% was lower than 9%. Spreading the fee over a one-year term showed the bank loan's APR was about 10%, since 7% interest plus the 3% cost of the fee comes to 10%.
The supplier line, at 9%, was therefore less expensive. This illustrative case shows why the headline rate should never be the only number compared. She asked the bank to confirm the fee in writing before signing, and she recorded the comparison in the board papers so the decision could be reviewed later.
Watch out
Common mistakes
- Comparing loans using only the quoted interest rate, when different fee structures can reverse which loan is cheaper.
- Assuming APR and APY are the same, when APY includes compounding and APR usually does not.
- Believing the APR is the total you will pay, when it is a yearly rate and the total cost depends on the loan amount and how long you borrow.
Questions
People also ask
Does APR include all fees?
Not always, since the fees counted depend on local regulation, and items such as late charges or optional insurance are often left out.
Is a lower APR always better?
Usually, but you should also consider the loan term, repayment flexibility and any penalty for early repayment.
What is a good APR for a business loan?
It varies widely with the borrower's credit profile, the lender and market conditions, so the best approach is to compare several written quotes.