The difference between APR and simple interest rate explained
As a small business owner, it’s important you feel confident and in control when running your business, regardless of what hat you’re wearing. When it comes to seeking finance to help your small business grow, it’s good to understand what different financial terms mean, so you can comfortably compare product offerings and discuss loan options with providers.
Two standard financial terms are APR (annual percentage rate) and simple interest rate. But how do they differ? And how can you use them to your advantage? We explain.
What do APR and simple interest rate mean?
APR is the total annual percentage rate. This is the rate that can be used to calculate the cost of the loan, taking account of the reducing balance of the loan amount, expressed as an annual rate. (For these purposes, the cost of the loan is exclusive of fees.)
APR is often used by mortgage and credit card providers. It’s calculated by applying the rate to your loan’s reducing balance over time and standardised on an annual basis regardless of your actual term.
So, while APR can be used for comparison purposes, it cannot be used to calculate the amount of interest you’ll pay.
Simple interest rate, on the other hand, is the interest you pay your lender on top of the amount you actually borrow. The simple interest rate is a fixed percentage of that lump-sum amount.
What you need to know about APR and simple interest rate
You’ll find that an APR appears high for short-term loans but low for long-term loans, which can be confusing if you’re taking out a loan across several decades, for example – as you would usually do when taking out a mortgage.
For example, while your APR on a $500,000 home loan may only be 5%, you’ll need to also consider the total interest percentage (TIP), which is 100%. That means you will end up paying $1 million in total over the 30-year loan period.
By contrast, the simple interest rate has a fixed rate. Its formula is fairly easy to work out:
Principal amount x interest rate x length of loan (years) = simple interest
Let’s say you take out a $10,000 small business loan with a six-month term and an interest rate of 11%. The formula will be 10,000 x 0.11 x 0.5, which equals $550. That figure is the amount of simple interest you’ll need to pay over the length of the loan.
How do lenders approach APR vs simple interest rate?
Simple interest rate can’t be compared like-for-like with APR because it is not calculated in the same way. It’s also worth noting that while many customers are familiar with APR, more and more alternative lenders, such as Prospa, are using simple interest rate for greater clarity and simplicity, which is especially useful for time-poor small business owners.
When using the formula above, you’ll be able to work out your expenses on a simple interest rate, which may give you a more complete overview of your interest repayments over the life of your loan.
In all things financial, it’s important to have as much information at your disposal so you can make the best decision for your circumstances – and for the success of your business.
Calculating interest rates on small business loans
The profile of your business plays an important role in deciding how much interest a lender will charge you, so the more you can do to mitigate risk before making a loan application the better – that way, you’ll be more desirable to lenders.
If, for example, you run a startup that hasn’t been in business very long, doesn’t own many assets or have a high turnover, then you’ll be a greater risk to lenders than an established business with a history of strong annual profits.
The actual factors that come into play will depend on your chosen lender but you can expect they will consider:
- The type of business you run, its history and overall risk profile.
- Your annual turnover.
- What assets you have and their overall value.
- The type of loan you’re applying for – and why you are applying for it.
- Whether you’ve chosen a secured or unsecured loan.
The easy way to compare small business loans
At the start of 2019, Australia’s leading online small business lenders signed a new AFIA Code of Lending Practice – a code that Prospa was instrumental in developing. As part of the code, customers now receive a one-page standardised pricing disclosure tool with their loan contract.
This tool makes it easy to compare small business loans, offering a clear and concise loan summary before a loan is accepted, empowering you to make the best decision for your small business’s needs.
Using these terms to your advantage
Now that you understand what both APR and simple interest rate mean you can compare different products from different lenders to determine the best option for your needs.
Most importantly, you can use the simple interest rate formula to work out the simple interest on a loan and therefore get a better understanding of the interest you’ll need to repay over the course of the loan.
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