If you’ve ever shopped for a small business loan online, you probably haven’t seen annual percentage rates (APRs) used frequently. Instead, lenders will use factor rates, annualized interest rates, simple interest rates or other metrics to show the price of their loans. We investigate the reasons why online lenders have traditionally avoided using APRs.
What Is Annual Percentage Rate?
You’re probably familiar with the annual percentage rates that you see advertised with credit cards and mortgages. APRs on small business loans are the same—the APR represents the annual cost of the loan to borrower, inclusive of interest and fees (e.g., origination fees , processing fees, servicing fees, etc.). One of the great things about APRs is that they allow borrowers to make apples-to-apples comparison of loan offers. If lenders use different rates, such as factor rates or simple interest rates, it becomes difficult for borrowers to understand the total cost of borrowing when shopping around for the best loans .
Because the APR includes additional fees, it will be higher than the interest rate quoted by your lender. For example, let’s say you decide to take out a $100,000 business loan with an 8% fixed interest rate and a maturity of 10 years. Total fees associated with the loan are $2,000, including origination and servicing fees. The APR on the loan would be approximately 8.47%. In general, a lower APR is better, provided everything else is equal.
Why Don’t Alternative Lenders Use APR?
One major reason alternative lenders shy away from using APRs is that they claim the APR may not accurately reflect the cost of borrowing, especially for short-term loans. For instance, a small business with seasonal sale cycles might need a working capital cash infusion for four to six months out of the year. The small business owner could opt to take out a traditional bank loan with a low APR, but he might need to pay back the loan over several years.
Instead, he could take out a short-term working capital loan from an alternative lender with a higher APR, but finish paying back the loan in a year or less. Even though the APR may be higher for the short-term loan, the borrower may end up paying less overall than with the long-term loan. Using our previous example of the $100,000 10-year loan, the borrower would repay a total of $148,504. If the loan maturity was changed to six months, the total amount repaid would be $104,393, even though the APR would increase to 14.9%.
The dramatic increase in the APR in our scenario above is one reason why alternative lenders may avoid using it as a metric. In our example, the APR almost doubled and this would likely be a big sticker shock to any small business owner looking for a loan. In many cases, a high APR can be a good indicator to the borrower to avoid a loan, but as we showed above, this is not always the case.
APRs are a great tool for evaluating loan offers, but they shouldn’t be used in a vacuum. You should also look at the total repayment amount, the average payment amount and the frequency of repayment. In addition, consider the loan’s maturity. Frequently, short-term loans have higher APRs, but they may be a better option if you want to be debt-free quicker.
Staff, “Why Alternative Lenders Don’t Use APRs” NASDAQ, December 9, 2016. Accessed via: http://www.nasdaq.com/article/why-alternative-lenders-dont-use-aprs-cm719448