One financial question we get asked a lot is, what is the difference between APR (annual percentage rate) and simple interest? We’ll explain what these two rates are, how they differ, and how you can use them to your advantage.
What is an APR?
APR stands for Annual Percentage Rate. This rate refers to the yearly rate charged on your loan or earned by an investor.
If you’ve ever applied for a mortgage, car loan or personal loan, you may have seen a reference to APR. While it’s similar to an interest rate, the APR can also include other fees or costs. On a credit card, APR and the interest you’re charged might be the same. But, on a mortgage, car payment or business loan, the APR might include extra costs plus interest.
Whatever costs your APR includes, it’s always expressed as a percentage and is the rate that is used to calculate the annual cost of your loan, expressed as an annual rate. An APR is calculated by applying this rate to the reducing balance of your loan over the year, regardless of how long you take to pay back your loan.
An APR doesn’t take into account compound interest. So, while you can compare different APR rates, it’s not a good indication of how much interest you’ll owe on your business loan over the lifetime of your loan.
For example, if the APR on a credit card is 12% but you miss a monthly credit card payment, you’ll actually end up paying more than the APR because your interest has compounded how much you owe.
What is simple interest?
Simple interest is the interest you pay on top of what you borrow. If your personal loan has an interest rate of 12%, you’ll be charged this rate on top of the money you borrowed (if you don’t pay your card off each month.) A simple interest rate is a fixed percentage of the lump sum of what you owe.
Simple interest is a basic way of looking at interest, but it can be misleading.
The simple interest formula = Principle x Rate x Time (years).
The problem with applying this to your entire loan amount is that the calculation is based on paying back your loan in full after two years. However, most business loans are paid off month to month, reducing the amount of principal you pay.
How does simple versus APR affect the overall cost of a loan?
Comparing a Simple interest rate with an APR interest rate is like comparing apples and pears. But, if borrowers aren’t careful they could run the risk of thinking they’re comparing the same thing.
For example, if you took out a two-year loan with an 18% Simple Interest rate and a loan with an 18% Cumulative APR rate, you’d actually owe less money on the APR loan over time.
Your APR fortnightly payments would be lower than the same loan with the same rate but expressed as a simple interest rate.
What do I need to know when talking to a lender?
You don’t need to remember the formulas to understand that Simple Interest and APR are two different things. When talking to a lender make sure they can give you an APR for all rates of the loans you are discussing. That way you’ll know the yearly rate your loan will be charged including any fees or other charges.
The APR gives a more inclusive look at what you’ll pay when you borrow. Just make sure you’re comparing loans with similar term lengths to get an accurate depiction of costs.
Need a partner who can break down the small print for you?
At ThinkCap, we make sure lenders understand all aspects of the loans they apply for. Find out more here.
