Small business owners who need to borrow capital often look at the interest rate first when making a lending decision. The interest rate a lender charges represents what you will pay to borrow the funds. In effect, it is the price tag on your loan.
If you read an article about small business lending and APR, you may come away with the impression that it is the only aspect of your loan that matters. That simply is not true. Focusing on APR could lead to overlooking many other important terms and conditions that could have a more significant impact on your business.
What is APR?
Annual percentage rate or APR represents the total cost of a loan. When shopping for small business loans and comparing rates often banks will present the simple interest rate, but that does not represent the actual loan cost. APR includes all associated fees and other loan payments and will be higher than the simple interest rate.
Banks and lenders are now required to disclose APR because it can be so different from the interest rate. As a borrower, however, it is important to keep in mind that APR is just a guide.
The lender has no way to predict how many times you will make a late payment. They do not know if you will elect to auto-pay, in which case your loan often costs less, or pay by check. Therefore, they make their best estimates – using your credit history and other factors as a guide – to calculate your projected APR.
APR Comparisons Are Not Always Equal
If one lender offers you a loan with an APR of 15.45% and another offers a loan of 18%, you might think the first loan is the better choice. This would be a mistake. What is and is not included in APR is not standardized in the industry. When laying out two annual percentage rates side-by-side, it’s rarely an apple to apple comparison.
Common fees such as a credit report fee, an appraisal fee, or an attorney’s fee, may not be included in the first lender’s quoted APR. The fine print will contain the details of what the lender used in calculating APR. Since you have no insight into what excluded fees could cost, you cannot just add them to the percentage.
While the annual percentage rate may look like it offers a simple way to choose between multiple loan products, that is not the case.
APR Matters Less than a Great Opportunity
When borrowing, you should never pay more for the capital borrowed than the return it will generate when invested in your business. If you borrow money at a rate of 15% to fund an investment which will return 30%, then the interest rate you are paying to borrow matters less than your net 15% return.
Sometimes great opportunities present themselves to business owners, and they must move quickly. A competitor goes out of business, and you can buy their machinery at a massive discount, or capture some of their customers. Often, business opportunities such as these have a time limit on them.
When a business owner needs cash quickly, they do not have time to wait months for a bank’s underwriter to approve their loan. A business loan for bad credit, which can be approved within 24 hours and paid out in a few days, provides the solution. Underwriting often just needs a copy of your driver’s license and business certification, and proof of monthly cash flows, to approve the loan.
Because these loans require less documentation, however, than a bank loan the trade-off between fast and easy cash is that you will pay a higher APR. The amount you pay for capital, however, matters less than making money.
APR Matters Less than Making Money
When deciding whether or not to borrow to pursue a business opportunity, expand your business, or invest in growth initiatives, what matters most is the amount of money you will make. After all, if you pay $20,000 in interest but make $50,000 on the investment, you will be ahead by $30,000.
Business owners should calculate their projected return on investment when putting together a business plan. Divide the net income the investment will produce by the investment’s capital cost. For example, if your plan to expand a project business line will cost $35,000 in capital, but will generate net income of $75,000, that’s over a 200% return.
For an investment to be a sound business decision, your rate of return should always be higher than the rate you pay to borrow. It should also be higher than the rate you would receive on a risk-free investment, such as a U.S. Treasury Bond. That is because you deserve to be compensated more in exchange for taking on more risk.
You can rarely predict down to the penny how much new revenue an investment will produce, so err on the conservative side when calculating your returns. This protects your profit and lessens the risk that your investment will prove to be foolish. If you are happy with the amount of money you will net on a deal, that matters more than the APR on the capital used to fund it.
Low APR Does Not Mean it is a Good Loan
It would be a mistake to focus solely on the loan’s APR as a marker of a “good” loan. There are many other factors which contribute to an overall positive business loan experience.
How easy is it to apply for and get approved for the loan? If the lender promises a low APR, but you are still waiting to hear back on a decision two months later, it might not be the best loan for your business. Customer service responsiveness can make or break a loan experience; how easy is it to reach the lender? Do they answer your questions quickly and accurately? Is it a generally enjoyable experience?
When you take out a loan, you are essentially entering into a relationship with the lender. It could last several months to several years; therefore you want to do as much as you can to ensure it will not negatively impact your life and business.
As well, the APR presented by a lender assumes that you will pay it down over the loan’s term, rather than pre-pay it. If you take out a loan with high upfront costs and fees, and then pay it off early, that impacts your APR. When those high upfront costs are spread over a shorter time, it bumps the APR higher. If you do plan on pre-paying, it may affect your choice. A loan with a higher quoted APR but lower upfront costs might be a better choice than a loan that has a lower quoted APR.
Check to see if your business loan contains a pre-payment penalty before agreeing to its terms. Many lenders insert these penalties into a loan so that they are guaranteed to make their profit if you pay your loan off early. This pre-payment penalty might also mean that a particular business loan is not your best choice.
APR is just one aspect of what can make a loan right for your business, so do not make your borrowing decisions solely upon it.
APR Matters less if Your Business is at Risk
How much is the capital worth if your business is at risk? There are many moving pieces in a successful business, and even cautious business owners can find themselves in a precarious financial situation.
If a significant customer has not paid on time and your vendor is demanding payment, you may need to borrow to avoid having a lien placed against your business. A restaurant food vendor will not deliver without upfront payment, but you are low on cash until after the weekend rush. These are examples of times when it would be wise to borrow to keep yourself afloat, particularly if you are only borrowing for the short term.
Before borrowing to bail your business out of a temporary issue, have a repayment plan set up. You should never borrow unless you know you can repay the capital. Even in an emergency, sit down and evaluate your cash flow patterns and projected cash flows to choose a business loan that you have a reasonable expectation you can repay. APR will not matter in the slightest if you end up defaulting.
APR Matters less than Access to Capital
Banks boast great rates and low annual percentage rates, but they have low approval rates. Traditional lenders deny more than 75% of business loan applicants because they do not want to take on much risk. What is more, banks rarely work with individuals who have less than a stellar credit score.
Advertised APRs that a bank offers will be based upon an assumption of the borrower’s credit, which you can usually find in the advertisement’s footnotes. Typically, banks refuse to work with borrowers with credit scores below 650 and reserve their best rates for those with scores above 700 or much higher. Even if a bank advertises an excellent APR, it probably will not be the APR that they offer to you.
A great interest rate means absolutely nothing if you cannot access the capital. It also does not matter if you cannot access the right amount of capital.
Banks prefer to lend in larger amounts and for longer terms. They have high overhead costs for employees, branches, and more, which they must spread over the loan’s life to recover. These costs remain the same if they write a loan for $5,000 or $500,000, but their profit will be higher on a $500,000 loan. Therefore, they rarely lend in amounts of less than $150,000.
Smaller business owners may need just five thousand dollars for a few months. Oddly enough, it can be harder to borrow a more modest sum than hundreds of thousands of dollars. Alternative lenders have no problem issuing smaller business funding in the form of a merchant cash advance, but a bank with its great APR will tell you to apply elsewhere.
The final piece of access to capital is the ease of access. As noted above, banks can take months to approve a small business loan. At that point, a small business in crisis could have folded. A loan with a quick approval process will charge a higher interest rate because the underwriter does not have time to perform as much due diligence on your credit-worthiness. That higher APR could be the trade-off you make to receive funds in a timely fashion.
Small business owners may find that being able to access capital in the amount that they need, when they need it, is far more important than the loan’s annual percentage rate.
Some Final Thoughts on APR
It is tempting to focus just on APR and the interest you will pay on a loan when evaluating your funding choices. It is a quick and easy number that you can compare to another lender’s offer. You might not think you have the time to evaluate the loan as a whole and in the context of your business, but even asking your lender a few questions about the things that matter more than APR could help guide a better decision.
An annual percentage rate of 30% might make a business owner pause, but the decision to borrow should ultimately come down to how much value you get out of a deal. The purpose of borrowing, after all, is not to pay as little as possible for that money. It is to obtain capital to serve a business need on the path to success.