What Is APR and How Is It Calculated?

APR in plain terms

APR is the cost of borrowing for one year as a percentage of the amount borrowed, with fees included. A higher APR means a more expensive loan.

An interest rate tells you only what the lender charges on the balance. APR tries to capture the full price by adding fees that come with the loan, such as an origination fee. Two loans can share the same interest rate and still have different APRs if one charges a large upfront fee.

For consumer credit, APR has a standardized definition in federal law. For business loans, there is less uniformity. Different lenders may include different charges, and some commercial products do not quote an APR at all. That is why you should ask what is in the number. See how to calculate cost of debt for related methods.

Interest rate versus APR

The interest rate is the charge on the balance. APR adds fees and expresses the total yearly cost, so APR is usually higher than the rate.

Neither tells the whole story alone. Ask for the total repayment amount and the payment schedule too. Our article on business loan rates explains how they are set.

How APR is calculated: a worked example

A simple approximation divides total finance charges by the amount borrowed, then by the term in years. The exact APR requires solving for the rate that equates payments with the net amount received.

Here is an illustrative example. You borrow $50,000 for one year with a 1 percent origination fee of $500 and equal monthly payments that total $54,000 over the year. The finance charge is $4,000 of interest plus the $500 fee, or $4,500.

Simple approximation: $4,500 / $50,000 = 9 percent over one year. But you did not keep $50,000 for the whole year. You repaid the principal gradually, so the average balance was about half, and the true annual rate is closer to 16 to 17 percent. A proper APR calculation accounts for that by finding the rate at which the present value of all payments equals the net amount you received. Spreadsheets do this with the RATE or IRR functions.

The lesson: the shorter the term and the more you repay as you go, the higher the APR will be compared with the simple percentage cost.

Why APR can look high on short-term funding

A short term compresses a fixed cost into a few months, so annualizing it produces a large percentage even when the dollar cost is modest.

Suppose you pay $2,000 to borrow $20,000 for three months. The dollar cost is 10 percent of the amount. Annualized, that behaves like a rate several times larger, because the 10 percent is spread over a quarter of a year, and repayment started early.

An APR in the triple digits does not automatically mean a bad decision, but it is a signal to check the math. If the money lets you earn $6,000 in that quarter, the $2,000 may be a good trade. If it only keeps the lights on, the cost is a drag. Read total cost of a business funding offer to judge by dollars as well as percentages.

Factor rates and APR

A factor rate quotes the payback as a multiple, like 1.3, with no annual rate. To compare it with APR you must convert using the payment schedule.

Many working-capital offers use factor rates. A 1.3 factor on $30,000 means you repay $39,000, a $9,000 cost. It does not state a yearly percentage. If you repay in six months, the effective APR is far higher than it would be over two years, even at the same factor.

Always ask for the term and the payment schedule so you can convert. Read factor rates and what a 1.3 factor rate costs for examples. Some revenue-based products have no fixed term, because payments follow sales. In that case, estimate payback time from your average revenue.

What to ask a lender

Ask for the APR, total repayment, term, payment schedule, every fee and any prepayment rule. Compare offers by the same set of numbers.

A short checklist:

1. What is the total I will repay?
2. What fees are charged, and are they deducted from the funds I receive?
3. How often are payments taken, and how large?
4. Is there a benefit or penalty for paying early?
5. Does the quoted APR include all fees?
6. Is a personal guarantee or lien required?

Write the answers side by side for each offer. Convert them to a monthly-equivalent payment so offers with weekly and monthly schedules can be compared. Our guide on small business loan ROI then shows whether the return is worth the cost.

Judging cost by what the money produces

APR matters, but the better question is whether the profit from the funded project exceeds the dollar cost. Start with payback.

An owner who borrows $40,000 for inventory that returns $18,000 in profit will often accept a high APR, because the dollars work. An owner who borrows $40,000 for a vague plan should be wary of even a low APR.

ROI Funder starts from what the money will produce, then shows the true cost, payback period and monthly-equivalent payment before you sign. We consider 500+ FICO, 6+ months in business and $20,000+ monthly revenue. Offers range from $5,000 to $5,000,000, and applying uses a soft credit pull with no obligation. See term loans and working capital, or apply.