When evaluating business financing options, the annual interest rate is only part of the story. Lenders use different rate structures, such as interest rates, annual percentage rates (APRs), or factor rates. They may also deduct fees before funding. Two offers that look similar on the surface might yield very different results when you consider fees, repayment structure, and term length. To make wiser decisions, you need to understand the total cost of capital and use it to compare offers on equal terms.
Let’s first define the standard terminology.
Interest Rates
An interest rate represents the annual cost of borrowing expressed as a percentage of the principal amount. Traditional interest rate loans are amortizing, meaning your interest charges are calculated on your declining balance as you make payments.
For example, with a 15% annual interest rate on a $1,000,000 loan, you pay interest on the full $1,000,000 in month one, but by month two, you only owe interest on the remaining balance. This structure means you pay less total interest than if the rate applied to the full principal for the entire term.
APR (Annual Percentage Rate)
The APR includes the interest rate plus all associated fees, including origination, processing, and closing costs, expressed as an annual percentage. The APR gives you a more complete picture of what financing actually costs because it accounts for money deducted at funding.
The same $1,000,000 loan, with a 15% interest rate and a 1.5% origination fee this time, will have an APR of around 16-17% (see the detailed example below).
Factor Rates
Many alternative lenders use a factor rate rather than an interest rate or APR. A factor rate (such as 1.15 or 1.25) represents the total amount you’ll repay for every dollar borrowed, regardless of the loan term. For example, a factor rate of 1.15 on a $1,000,000 loan means you’ll repay $1,150,000 total.
The key difference: Unlike traditional interest rate loans, where your interest charges decline as you repay principal, factor rate loans charge you for the full borrowed amount throughout the entire term. Even though you’re making regular payments and reducing your balance, you still owe the full cost as if you kept the entire $1,000,000 for all 12 months.
A 1.15 factor rate, which might appear to represent a 15% cost of capital, actually translates to an APR of approximately 28-30% when you account for the non-reduced principal balance, nearly double the simple markup.
A $1,000,000 Loan - Interest Rate Example
Let’s consider the detailed example below to illustrate how to calculate the total cost of capital for a traditional amortizing loan.
- Financing Amount: $1,000,000 Interest
- Rate: 15%
- Annual Term: 12 months
- Origination Fee: 1.5% ($15,000)
- Received Amount: $985,000*
- Monthly Payment: $90,260
- Total Repayment: $1,083,120
* The received amount is slightly lower than the financing amount because the lender deducted a 1.5% origination fee at funding.
Calculating the Interest Cost
The interest cost is the difference between the total repayment and the original financing amount:
Total Interest = $1,083,120 − $1,000,000 = $83,120*
This is the cost of borrowing before any other fees are added.
* Notice this is lower than the $150,000 in the example above, as you are only paying interest on the paid-down balance each month.
Determine the Total Cost of Capital
Now add back any required fees, such as the origination fee:
Total Cost of Capital = $83,120 + $15,000 = $98,120
This amount represents the complete cost of accessing and repaying this financing.
Calculate the APR
The APR uses the same principle as the Internal Rate of Return (IRR), a financial metric that accounts for the time value of money. It accounts for the timing of each payment, the total number of payments, the amount you actually receive after fees, and the fixed payment amount over time.
The stated interest rate is 15%, but once you account for the $15,000 origination fee that was deducted from the amount you received, the actual APR is higher.
In our $1,000,000 example, the stated interest rate is 15%, but you received only $985,000 after fees and made 12 monthly payments of $90,260. Using the IRR method described above to account for the reduced amount received and payment timing, this translates to an APR of approximately 16.7%.
The origination fee increased your effective cost from 15% to 16.7% because you received less money upfront, but still paid the same interest as if you had borrowed the full $1,000,000.
Because this calculation involves compounding and payment timing, most lenders, financial advisors, and borrowers use spreadsheets or financial calculators to compute it accurately.
A $1,000,000 Loan - Factor Rate Example
Now, let’s compare this to a factor rate loan that might appear similar:
- Financing Amount: $1,000,000
- Factor Rate: 1.15
- Term: 12 months
- Origination Fee: 1.5% ($15,000)
- Received Amount: $985,000
- Total Repayment: $1,150,000
- Monthly Payment: $95,833
Calculate the Factor Rate Cost
To calculate the Factor Rate Cost, deduct the Received Amount from the Total Repayment:
Factor Rate Cost = $1,150,000 − $1,000,000 = $150,000
This amount compares to the Total Interest of $83,120 in the examples above.
Determine the Factor Rate Total Cost of Capital
Now add back associated fees, such as the origination fee in our example:
Total Cost of Capital = $150,000 + $15,000 = $165,000
This amount compares to the Total Cost of Capital of $98,120 in the examples above.
Cents on the Dollar
In factor rate transactions, many focus instead on the cost per dollar borrowed. To do so, divide the cost by the financing amount:
Cents on the Dollar = ($150,000 + $15,000) ÷ $1,000,000 = $0.165
You’re paying 16.5 cents per dollar borrowed, including all fees. The base factor rate (before fees) is calculated as total repayment divided by amount borrowed:
Base Factor rate= $1,150,000 ÷ $1,000,000 = 1.15.
Calculate the APR
To calculate the APR, you need to account for the amount received ($985,000) and the timing of the monthly payments ($95,833 each month). This requires an IRR calculation, which measures the actual cost of the loan when payments are made over time rather than all at once.
The APR for this same transaction with a 1.15 factor rate and a 1.5% origination fee equates to approximately 28%
The Comparison
The 15% interest rate loan costs $98,120 total with a 16.7% APR. The 1.15 factor rate loan costs $165,000 total with a 28% APR. The factor rate loan costs $66,880 more, even though the factor rate of 1.15 appears similar to a 15% interest rate. The true APR is 28%, nearly double the 15% that the factor rate might suggest. A 1.15 factor rate and a 15% interest rate are not equivalent.
Why Repayment Frequency Matters
Beyond the rate structure, payment frequency affects your cash flow. The 15% interest rate loan requires $90,260 per month, while the factor rate loan requires $95,833 per month.
Daily or weekly repayment schedules, often available with factor rate transactions, work well if you have consistent daily revenue (like retail or restaurants). Still, monthly payments usually align better with B2B businesses that invoice on net-30 or net-60 terms. Match your repayment frequency to your revenue cycle for smoother cash management.
Putting It All Together
In terms of total cost of capital, your actual annual cost of capital, or APR, tells the story. In the examples above, a 15% interest rate loan with a 1.5% fee cost $98,120, or 16.7% APR, while a 1.15 factor rate loan with the same fee costs $165,000, or 28% APR. A factor rate that looked like a 15% markup actually cost nearly twice as much when accounting for payment timing. Always calculate the APR before making a decision.
How to Use This When Reviewing Offers
Before accepting any financing offer, determine:
- Is this an interest rate loan (amortizing) or a factor rate loan (fixed total repayment)?
- What is the total repayment amount?
- What fees are deducted from the amount you receive?
- What is the payment frequency (daily, weekly, or monthly)?
Understanding the effective APR requires financial calculations that take payment timing into account. Most lenders should be able to provide you with the APR if you ask. You can also work with a financial advisor or use online APR calculators designed for business loans to verify the numbers yourself.
Key Takeaways
- Interest rate loans and factor rate loans are fundamentally different. A 1.15 factor rate is not equivalent to a 15% interest rate.
- Always calculate the APR. Other calculations may ignore associated fees or the time value of money.
- Ask lenders to disclose all fees upfront and clarify whether the loan is amortizing (interest on declining balance) or fixed repayment (factor rate structure).
- Use this same approach for any type of financing, including asset-based lending, specialty finance, SBA financing, or real estate financing.
- While the lowest total cost is usually the best choice, faster funding or flexible terms may sometimes justify a higher cost. What matters is that you understand the trade-off and choose financing that genuinely supports your business’s growth.
Understanding these numbers helps you compare lenders accurately and make informed decisions.
Note: All dollar amounts in examples are rounded to the nearest dollar for clarity.