Annual Percentage Rates Fail Business Owners, Again

A survey of small businesses once again revealed that Total Cost of Capital (TCC) was a better metric than Annual Percentage Rate (APR) when choosing a small business loan. This study, conducted by Edelman Intelligence on behalf of the Electronic Transactions Association (ETA), found that a majority of respondents stated that they would look to minimize TCC, rather than APR, when considering loan options in the face of a short-term ROI opportunity.

The ETA explained this in the report as follows:

Generally, when consumers take out a loan, they are not making an income-generating investment that would increase the funds available to pay the loan back. Therefore, in most situations, the more “affordable” loan for a consumer is one with a longer term and lower monthly payments, even if it results in paying more over the long term. Consumers, therefore, look at APR, which describes the interest and all fees that are a condition of the loan as an annual rate paid by a borrower each year on the outstanding principal during the loan term. APR takes into account differences in interest rates and fixed finance charges that may otherwise confuse a consumer borrower and is most useful in comparing similarly long-term loans, such as 30-year mortgages or multi-year auto loans. Likewise, APR is useful for comparing revolving lines of consumer credit, like credit cards, where the amount borrowed each month changes. APR allows consumers to compare the rate at which an outstanding balance would increase under different credit cards.

While APR describes the cost of the loan as an annualized percentage, TCC represents the sum of all interest and fees paid to the lender. As the Cleveland Federal Reserve recently noted, TCC enables a small business to determine the “affordability” of a product – a key driver for most small business borrowers. Unlike consumer loans, commercial loans are normally used to generate revenue by helping a business purchase equipment or inventory or hire additional employees. Thus, “affordability” for small business borrowers means assessing the cash flow impact of the loan and comparing the TCC of the loan and the return they expect to earn from investing the loan proceeds. To reduce TCC, many small business borrowers prefer short-term financing they can quickly pay back with the return on their investment (ROI).

The ETA’s full report can be VIEWED HERE.

The findings are consistent with other studies:

When Comparing Loan Options, Small Business Owners Say “Total Payback Amount” is Easiest to Understand; APR and Factor Rate More Difficult

Fed study on small business borrowing

A debate with anecdotal evidence, demonstrating people’s inability to calculate an APR

Consumers also struggle to make sense of APR, according to a 2008 Fed study

An old debate on twitter regarding APR vs TCC

Sean Murray is the President and Chief Editor of deBanked and the founder of the Broker Fair Conference. Connect with me on LinkedIn or follow me on twitter. You can view all future deBanked events here.