Annual Percentage Rate (APR) and Simple Annual Rate (Simple Interest) are both commonly used rates to represent the cost of business or commercial loans in Australia. Whilst both are valuable in evaluating loan costs, it's crucial for businesses to understand their differences to grasp the true cost of borrowing.
What is Simple Interest or a Simple Annual Rate?
Simple Interest is exactly what it says on the tin – a straightforward way to understand the total interest cost of a loan. A Simple Annual Rate represents the Simple Interest cost on an annual basis.
As an example, if you borrow $100k over a one-year term with a Simple Annual Rate of 10%, the cost of the loan would be $10k. If you borrow $100k over a two-year term with a Simple Annual Rate of 10%, the cost of the loan would be $20k. Here’s the formula for calculating the Simple Interest cost:
Simple Interest $ = Principal x Simple Annual Rate x Time (in years)
Pros and Cons of a Simple Annual Rate?
As an example, if you borrow $100k over a one-year term with a Simple Annual Rate of 10%, the cost of the loan would be $10k. If you borrow $100k over a two-year term with a Simple Annual Rate of 10%, the cost of the loan would be $20k. Here’s the formula for calculating the Simple Interest cost:
Simple Interest $ = Principal x Simple Annual Rate x Time (in years)
Pros and Cons of a Simple Annual Rate?
- Pro: It's an easy way to understand the total interest expense payable on a loan, which is helpful for business owners to compare the cost of borrowing vs. the return they are making from the money.
- Con: A Simple Annual Rate doesn’t take into account the structure of the loan and how the principal is repaid over the life of the loan, which makes it difficult to compare across different loan products.
What is an APR?
An APR is used to calculate the effective cost of a loan expressed as a percentage. It takes into account the loan structure and how the principal is repaid over the life of the loan. This is where things become complex because an APR will change based on many factors. For example, it will vary based on whether the loan is structured with weekly or monthly repayments.
Using the example above, a $100k loan over a one-year term where the Simple Annual Rate is 10% and the simple interest cost is $10k, the APR might be 17.98% based on the loan structure and monthly repayments. If you change this to weekly repayments, the APR increases to 19.06%. This is despite the total interest expense remaining at $10k in both cases.
An APR is typically seen as a more accurate measure of the cost of borrowing because it looks beyond just the interest paid on the loan and enables you to compare apples with apples across different products and lenders.
Pros and Cons of an APR?
Using the example above, a $100k loan over a one-year term where the Simple Annual Rate is 10% and the simple interest cost is $10k, the APR might be 17.98% based on the loan structure and monthly repayments. If you change this to weekly repayments, the APR increases to 19.06%. This is despite the total interest expense remaining at $10k in both cases.
An APR is typically seen as a more accurate measure of the cost of borrowing because it looks beyond just the interest paid on the loan and enables you to compare apples with apples across different products and lenders.
Pros and Cons of an APR?
- Pro: Given it takes into account the structure and repayment profile of a loan, it’s useful to compare the effective cost of loans across different lenders and products.
- Con: It doesn’t provide a clear indication of the total interest cost across the life of a loan, so it’s helpful to also look at the cost in dollars and not just the APR.
Both the Simple Annual Rate and APR are critical in assessing the cost of business loans. While the Simple Annual Rate offers a clear view of the total interest cost, an APR provides a comprehensive understanding by factoring in loan structure and repayment profiles, enabling better comparisons across different loan products and lenders. Understanding these metrics can help businesses make informed borrowing decisions.
