Factor rates and APR explained
Interest charges are generally the main cost of any loan additional to the principal amount, and borrowers generally aim to find the lowest rates possible in hopes of obtaining the cheapest loan possible.
In Australia, most loans are presented with an advertised interest rate and a comparison rate. The advertised rate only refers to the interest charges on the loan, while the comparison rate includes both interest charges and any fees which may increase the total cost of the loan.
A comparison rate is therefore more beneficial, making it easier to compare multiple loan offers based on their true, total cost. However, business loan lenders in Australia may occasionally use a factor rate in place of an interest rate, which can be confusing to borrowers who may only be familiar with traditional interest rates.
Factor rates are common when advertising business loans with terms of less than 12 months.
To understand the true cost of a business loan when only a factor rate is provided, borrowers will need to convert the factor rate to the Annual Percentage Rate (APR), which displays the interest rate as it would be if charged over a 12-month period.
How do factor rates work?
A factor rate is an interest rate presented in decimal form, and is immediately applied as a base interest rate to the principal amount. For example:
- A borrower applies for a business loan with a factor rate of 1.15
- The loan principal is $30,000 and the term is six months
- The lender applies the factor rate to the loan amount (30,000 x 1.15)
- The interest charge on the loan is $4,500
- The total repayment amount of the loan is $34,500
A factor rate is especially relevant if a business plans to borrow money and make early repayments to save on interest. As the factor rate is immediately applied to the principal amount at the beginning of the loan term, any early repayments made by the business will have no effect on interest savings.
As there is no way to save on interest with a loan using a factor rate, it's imperative that borrowers understand the cost of the loan before committing to an agreement with a lender. The easiest way to do this is by converting the factor rate to an effective APR.
Below, you can see how the loan from the previous example would be presented if using an effective APR.
Example of factor rate to APR conversion
|Loan Term||6 months|
How the factor rate to APR calculator works
If you'd like to verify your results, or you're interested in doing the calculations yourself, here's how to calculate the APR and effective APR on a loan using a factor rate.
You will need:
- The principal loan amount
- The term of the loan
- The factor rate of the loan
- The fees included - if any
Using the example presented earlier, you will need to take the interest charges of the factor rate (0.15 on a factor rate of 1.15, where 1 is indicates the principal amount and 0.15 is the relative interest charge) and multiply this by 365. This will provide our APR (the amount you'd pay if taking a similar loan for 12 months).
0.15 x 365 = 54.75 = 54.75% APR
The next step is to divide this result by the length of your loan term in days. For our six-month term loan in the earlier example, the number of days will be 180. Assuming there are no fees included in the loan amount, this result will be your effective APR.
54.75 / 180 = 0.3042 = 30.42% effective APR
If your loan includes any fees, you can repeat the process to find the additional percentage increase as a result of the fees included in your loan. For example, if the loan above includes $500 in fees, you'll first divide the fees by the principal amount to display a decimal result (fees represented as a factor rate):
500 / 30,000 = 0.0167
Then repeat the above steps to find the additional interest rate increase as a result of the fees:
0.0167 x 365 / 180 = 0.0339 = an additional 3.39% added to the effective APR to account for the fees.
You would then add both rates together to find your final, effective APR (which functions identically to a comparison rate):
30.42% + 3.39% = 33.81% (Interest APR + Fees APR)