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Updated: Feb 6, 2020
The terms interest rate and annual percentage rate (APR) are frequently used interchangeably, but it is important to understand the difference between the two.
For small business owners, it is also important to understand how the annual percentage rate is calculated depending on the type of financing offered.
The interest rate on a loan represents the current rate of borrowing. The APR, on the other hand, represents the total interest payable on the loan, on a yearly basis, averaged over the duration of the loan. This is inclusive of fees and service charges.
Depending on the type of financing sought, there can be significant variations in APR. APRs are typically higher than interest rates.
A term loan is one of the most common forms of financing. It has a set number of payments within a specified time period, at a fixed (unchanging) or variable (changing) APR.
Term loans are usually for terms of 1 to 10 years. The APR of a term loan is calculated using the loan amount, the interest rate for the loan, origination and application fees, service charges (if any), and the loan term.
Initial Loan Amount: $75,000
Loan Term: 24 months
Interest rate: 10% (fixed)
Origination fee: 3%
Monthly payment: $3,460.87
Total repayment: $83,060.87 (principal + interest)
Cost of loan: $10,310.87 [(83,060.87 – 75,000) + (0.03 x 75,000)]
In general, a fixed rate loan will have a higher initial interest rate, compared to a variable APR loan. The variable loan has an APR based on the current market value; the borrower assumes the risk that the variable rate may increase during the term of the loan.
Merchant Cash Advances (MCAs) have higher APRs than term loans.
Rather than base the APR on the borrower’s credit score and requiring payment in fixed installments, MCAs are an advancement on future credit and debit card sales.
The borrower pays a fixed percentage of daily credit and debit card sales to the lender for the initial advancement amount – plus additional interest and fees – until the loan has been repaid in full.
Advanced amount: $50,000
Payback amount: $55,000
% of future card sales: 15%
Projected monthly card sales: $45,000
Origination fee: 3%
Estimated daily payment: $225.00
Repaid in about: 244 days (8 months)
Total cost of Merchant Cash Advance: $6,500.00
Estimated APR: 38.24%
Merchant cash advances are usually for less than 24 month terms. They are used by many small businesses without the financial history or credit score needed to secure a loan with a lower rate.
With payments based on sales, business owners do not have to be as concerned about bringing in enough to make a payment, if they have a slow week or month.
Samantha Novick is a senior editor at Funding Circle, specializing in small business financing. She has a bachelor's degree from the Gallatin School of Individualized Study at New York University. Prior to Funding Circle, Samantha was a community manager at Marcus by Goldman Sachs. Her work has been featured in a number of top small business resource sites and publications.