If you’re looking for a small business loan, you may find yourself overwhelmed by the abundance of acronyms, like APR, APY, and EAR. Understanding what they mean may often be the difference between obtaining funding at a competitive rate and dealing with a costly loan. Find out more about the differences between EAR and APR and what pieces of information matter most when you’re scaling your business.
What is APR?
There are many types of small business loans, including term loans, SBA loans, lines of credit, equipment financing, and commercial real estate loans. No matter what type you’re pursuing, the goal is to obtain the most affordable funding that meets your company’s needs. One of the first numbers lenders will show you is the APR, and it’s meant to help you do exactly that. APR, or annual percentage rate, represents the yearly cost of borrowing, expressed as a percentage.
For small business borrowers, APR is most useful as a comparison tool. It shows how expensive one loan is relative to another by factoring in not just the interest rate but also certain lender fees. When you’re weighing a bank loan against an online lender, APR gives you a standardized way to evaluate cost without digging into every line item.
While useful, APR doesn’t paint the entire picture. Since it doesn’t reflect how interest compounds over time, APR may sometimes underestimate the true cost of a loan.
Example of APR
Assume that you receive a $10,000, one-year business term loan, and that it comes with a 10% APR. Over the course of the year, you will be responsible for paying $1,000 in interest, which brings your total debt repayment to $11,000. Assuming that there are no other variables that impact the payment, you could expect to pay around $916 per month for 12 months.
What is included in APR?
Typically, APR includes the following:
- · Interest rate
- · Origination fees
- · Closing costs
- · Guarantee fees (for SBA loans or guaranteed products)
- · Other administrative costs
How to calculate APR
APR is calculated by spreading the total interest and eligible fees across the loan term and expressing that cost as an annualized percentage. While there is a stated formula behind it, most small business owners don’t need to calculate APR themselves since lenders are required to disclose it.
It’s important to remember that APR is a baseline indicator, not a precision tool. It’s great for comparing similar products, but it doesn’t provide a detailed look into how compounding interest will impact the loan. For that, you’ll need to use EAR.
What is EAR?
EAR stands for effective annual rate, sometimes referred to as APY. Unlike APR, EAR accounts for compound interest, meaning it reflects the real-world cost of borrowing when interest is applied repeatedly throughout the year. This is why EAR is always equal to or higher than APR.
For small business owners, EAR is especially relevant when evaluating lines of credit, credit cards, and loans that compound monthly. While these products are often advertised with low APRs, compounding may significantly impact the amount that you pay over the life of the loan.
Example of EAR
Imagine that you take out the same $10,000 loan that we considered earlier. However, this one comes with a 12% APR that compounds monthly, which is typically common with revolving credit products. Every month, interest is applied to the principal amount owed and any accrued interest.
Over the course of the year, that monthly compounding pushes the effective annual rate to about 12.7%, even though the advertised APR is only 12%. That difference may seem small, but over longer terms or with higher balances, it can add up to a meaningful extra cost.
How to calculate EAR
To calculate EAR, take the APR and adjust it for how often the interest compounds throughout the year. The more frequently interest compounds, the higher the EAR becomes. Monthly compounding results in a higher EAR than annual compounding, and daily compounding increases it further.
Much like APR, most borrowers don’t need to calculate these terms on their own. Instead, simply remember that the EAR provides a more detailed picture of borrowing costs.
Which rate should small business owners focus on?
For most small business owners, APR is typically the best starting point when comparing financing options. APR reflects the total cost of borrowing by including interest, lender fees, and certain up-front costs, making it easier to compare loan offers side by side.
However, EAR still holds some value, especially when evaluating how interest compounds over time. EAR is great for loans with frequent compounding periods or unconventional repayment structures. EAR shows the actual annual return the lender earns, which can highlight how compounding increases costs beyond the stated rate.
What's the difference between EAR and APR?
When searching for a loan that will help your business grow, it's important to understand the differences between EAR and APR as well as how they relate to one another:
- APR is the simple interest rate charged on borrowed funds over the course of the year. It is more frequently the percentage used to compare loans and credit cards quickly because it also accounts for fees and closing costs.
- APR is most effective for loans like fixed-rate mortgages, which have a balance that doesn't fluctuate like revolving credit.
- APR does not account for compound interest, whereas EAR calculates compound interest and serves as a more accurate representation of the cost of borrowing money over time. On a credit card, for example, carrying a balance month over month will increase the EAR, resulting in a higher rate than the advertised APR.
- EAR is determined by the number of compounding periods per year. When accepting a loan, for example, 12 compounding periods will always result in a higher EAR than a loan that compounds quarterly.
How Smartbiz® may be able to help
The decision to borrow funds for your small business is a big one. With so many options, choosing the right one can feel overwhelming. Find out more by seeing if you pre-qualify today.
FAQs
Which interest rate is more important when comparing loans: APR or EAR?
APR is generally the best way to compare different loans. It includes interest and certain fees, making it easier to evaluate competing term loans or SBA loans. EAR becomes more important once you’re trying to understand the true long-term cost, especially for loans with frequent compounding.
Why is the EAR usually higher than the APR?
EAR is usually higher than APR because it accounts for compounding interest. Because of this, EAR will never be lower than APR, though they can occasionally be equal.
Do lenders show APR or EAR on small business loans?
Most lenders typically disclose APR on small business loans since it’s the standard regulatory metric. However, if EAR is not listed, borrowers can request that information from the lender or calculate it themselves.
How do compounding periods affect EAR and APR?
Compounding does not affect APR at all since the annual percentage rate of a loan does not account for compounding interest. Conversely, EAR increases as compounding becomes more frequent. This is why revolving credit products, such as lines of credit, often cost more than they initially appear to cost.
Which rate better reflects the true cost of a loan?
EAR accurately reflects the true cost of borrowing money. It shows what you actually pay once compounding is factored in, making it especially useful for lines of credit and longer-term borrowing.
