Feel like you need a financing glossary on hand every time you talk with your lender? Overwhelmed by unfamiliar jargon whenever you research your financing options? You’re in luck! We’ve rounded up the most important terms every borrower should be familiar with before choosing a small business loan. Add these terms to your vocabulary—you’ll need to know them when deciding on the perfect loan for your business.
Principal, Interest, and Interest Rates
Let’s start with the easy stuff. Your principal amount is simply the amount you borrow from your lender and does not describe any interest or fees you’ll eventually owe.
Interest is the cost of borrowing that principal amount from your lender. Your interest rate is the percentage of that borrowed amount you’ll owe come payment time, in addition to the payment you’ll make towards the loan itself. If you’ve got a traditional, long-term loan, your interest payments will change as your total amount owed changes. Note that when your lender gives you an interest quote, it will not include additional fees associated with your loan. To get that number, you’ll need to look at your APR.
Annual Percentage Rate (APR)
An APR (sometimes called an “effective interest rate”) is the annual cost of your loan. It provides a more complete view of what you owe. Like your interest rate, it’s quoted as a percentage, but it also includes all those additional fees (origination fees, closing fees, documentation fees, etc.). If you’re wondering why your APR quote is higher than your interest rate, those fees are the reason why.
Because your APR depends on several factors, including your lender and your credit, you may have to hunt this figure down or estimate it yourself before moving forward with your loan application.
Don’t make the mistake of agreeing to a loan with a low monthly payment before getting a full picture of its annual cost to you. Make sure you understand both your interest rate and your APR before signing on the dotted line.
Speaking of additional fees, there’s one, in particular, every smart business owner should understand: your origination fee. These charges cover the cost of processing your application, reviewing your paperwork, verifying your information, etc. You might see this figure written out as a percentage or a flat fee. In many cases, you’ll be charged interest on this fee as you pay it over time, just as you would on your loan.
Amortizing Versus Simple Interest Loans
These two types of loans offer different ways of paying off your principal amount and your interest. Amortizing loans mean your principal payments will increase over time, while your interest payments decrease over time. Amortizing loans are better for keeping your monthly payments low while spreading them out over a longer term.
Simple interest loans mean your principal and interest payments will always be the same. While you might find the total you pay back is lower on this type of loan as they tend to be for shorter periods, be warned that simple interest loans may come with a higher APR, plus prepayment penalties if you pay off your loan early. Ask your lender to clarify.
If you’ve applied for a short term loan or merchant cash advance rather than an amortizing loan through a traditional lender, your lender will charge you all your interest from the start, meaning you’ll make the same interest payment each month. The amount you pay is determined by your factor rate, a multiplier that typically falls between 1.1 and 1.5. To find out how much the loan-plus-interest will cost you, just multiply your loan amount by its factor rate.
Before you put pen to paper on any loan agreement, make sure you understand what you’ll pay annually, what happens if you pay early, and how much you’ll have paid when your debt is finally cleared. Knowledge is power, business owner—arm yourself with information and rest assured you’ve chosen the right financing for your business.