Small Business Center
By Ty Kiisel, Nav
There are more small business loan options available today than ever before, but small business owners need to be savvier as they explore their options and choose the financing that’s right for them. For example, comparing the costs of financing is more challenging today than it was when options were limited to traditional lenders like banks and credit unions. Understanding the differences between annual percentage rate, interest rate and total dollar cost will help you make apples-to-apples comparisons when evaluating any type of financing, whether it’s a term loan, a merchant cash advance or invoice factoring.
There was a time when all you needed to know was the APR to make a comparison — today, some financing options like an MCA don’t even express costs in an APR — but that isn’t the case anymore. APR is a tool to compare similar loans with similar terms, but it doesn’t tell the whole story.
If you’ve ever purchased a new car or bought a home, you’ve probably compared the APRs of at least a couple of lenders. APR is the annualized interest rate for the entire year, including any fees. It’s not the same thing as an interest rate expressed monthly, weekly or daily on a small business loan. If APR is the annualized rate, what is the interest being annualized? If you think of interest as the cost of capital in terms of what a lender is charging at specific intervals, you can make a simple calculation to understand what the actual interest rate would be. At the risk of oversimplifying, the calculation looks like this:
APR / Payment Interval = Interest Rate
For a 10% APR with a monthly payment interval, divide the APR by 12, so 10 divide by 12. The result is 0.83%.
For a 10% APR with a daily payment interval, divide the APR by 365, so divide 10 by 365. The result is 0.02%.
As the payment frequency increases, the interest charged per payment drops. As you can see, thinking about APR in relation to the number of payment intervals illustrates that when you’re comparing loans with different payment frequencies or loan types, APR doesn’t give you all the information and can even cause some confusion.
This is even more apparent when looking at short-term financing. For example, let’s compare a six-month term loan with a 10% APR. Note that there are 120 days in six months. For a monthly periodic payment, 10 divided by 6 equals 1.67%. For a daily periodic payment, 10 divided by 120 equals 0.08%. Although the APR is the same in both, the amount of interest the borrower pays with each payment is different. Because this makes it challenging to make an accurate comparison of the costs of different loan types, it’s important to understand total dollar cost.
The total dollar cost of a loan isn’t a difficult number to understand, but it might not be obvious without a little arithmetic. Subtract the principal amount from the total of all the payments (this will include all interest and any fees). The difference will be the total dollar cost.
As a general rule, shorter-term financing will come at a higher APR, but that doesn’t mean a higher overall dollar cost. Additionally, the shorter the term, the higher the periodic payments likely will be but the lower the total dollar cost could be.
|Amount||Loan type||Loan APR||Term||Payback||Total cost||Cost per Dollar|
|$30,000||SBA 7(a)||6% APR||7 years (monthly)||$36,613.47||$6,813.47||$0.22|
|$30,000||SBA 7(a)||6% APR||10 years (monthly)||$39,967.43||$9,967.43||$0.33|
|$30,000||bank term loan||7% APR||5 years (monthly)||$35,642.12||$5,642.12||$0.18|
|$30,000||bank term loan||7% APR||10 years (monthly)||$41,798.87||$11,798.87||$0.39|
|$30,000||longer-term online loan||30% APR||3 years (daily)||$40,650.09||$10,650.09||$0.35|
|$30,000||longer-term online loan||30% APR||5 years (daily)||$48,839.01||$18,839.01||$0.62|
|$30,000||shorter-term online loan||40% APR||3 months (daily)||$31,013.58||$1,013.58||$0.03|
|$30,000||shorter-term online loan||40% APR||6 months (daily)||$32,032.24||$2,032.24||$0.07|
|$30,000||merchant cash advance*||160% APR||3 months (daily)||$34,183.25||$4,183.25||$0.13|
|$30,000||merchant cash advance*||160% APR||6 months (daily)||$38,643.09||$8,643.09||$0.29|
* Merchant cash advances are not typically expressed in APR. This calculation is a conversion of the interest, fees and other costs and is for example only.
A loan that otherwise might not be considered could make sense depending on the loan purpose or the reason a small business owner might be borrowing, and total cost makes it easier to compare one loan type to another. If you ask your lender to provide you with the total payback amount, this is a pretty easy comparison to make.
Most people wouldn’t even consider a 30-year auto loan regardless of how low the APR might be. That loan type just wouldn’t make sense to meet the loan purpose. The same is true for comparing loan purposes like purchasing quick-turnaround inventory, bridging a seasonal cash flow gap, purchasing a new warehouse or building another location across town. There is no one-size-fits-all loan that would work equally well for buying inventory or building a new warehouse.
When most people think of a small business loan, they think of the traditional bank or Small Business Administration loan, which in many cases is the right choice. When comparing loans that have similar terms and similar periodic payment frequency, APR is a reasonable way to compare, but it might not be the best loan or the best way to compare when considering a longer-term loan and a shorter-term loan. This is particularly true when a defined return on investment for the loan exists. In those cases, the business owner should be asking, “What is the total cost of the loan?” and, “How much per dollar is this loan going to cost?” to make a more meaningful comparison. Make sure you compare APR, interest rate and total dollar cost.
This article was originally published at www.nav.com.