How Business Loan Interest Is Calculated: Simple vs Compound vs Factor
Understand the three main ways business loan interest is calculated: simple interest, compound interest, and factor rate. Learn which method costs more.
The way interest is calculated dramatically affects your total cost. The same "rate" can mean very different things depending on the method used.
This guide explains the three main interest calculation methods used in business lending.
Method 1: Simple Interest
Simple interest is calculated only on the original principal amount. As you pay down the loan, you pay less interest.
- Formula: Interest = Principal x Rate x Time
- Example: $100,000 x 10% x 1 year = $10,000 interest
- Benefit: Prepayment reduces total interest paid
- Common for: SBA loans, bank term loans, traditional financing
Daily Accrual
Most simple interest loans calculate interest daily. Pay off the loan early, and you pay less interest. This is the most borrower-friendly method.
Method 2: Compound Interest
Compound interest charges interest on both principal and accumulated unpaid interest. Interest earns interest.
- Formula: A = P(1 + r/n)^(nt) where n = compounding periods
- Impact: More expensive than simple interest at same rate
- Compounding frequency: Daily, monthly, quarterly, or annually
- Common for: Credit cards, some lines of credit
Compare simple vs compound on a $100,000 loan at 10%:
| Method | 1 Year Interest | 5 Year Interest |
|---|---|---|
| Simple interest | $10,000 | $50,000 |
| Compound (annual) | $10,000 | $61,051 |
| Compound (monthly) | $10,471 | $64,530 |
| Compound (daily) | $10,516 | $64,872 |
Method 3: Factor Rate
Factor rate is a fixed multiplier applied to the principal. You owe the same amount regardless of when you pay.
- Formula: Total owed = Principal x Factor Rate
- Example: $100,000 x 1.30 = $130,000 total owed
- No prepayment benefit: Pay early, still owe full amount
- Common for: Merchant cash advances, short-term online loans
The Factor Rate Trap
A factor rate of 1.25 sounds like 25% interest, but on a 6-month term it equals roughly 50% APR. Factor rates always cost more than they appear.
Converting Factor Rate to APR
To compare factor rate loans to traditional loans, convert to APR:
| Factor Rate | 6-Month Term APR | 12-Month Term APR |
|---|---|---|
| 1.15 | ~60% | ~30% |
| 1.20 | ~80% | ~40% |
| 1.25 | ~100% | ~50% |
| 1.30 | ~120% | ~60% |
| 1.40 | ~160% | ~80% |
Why Factor Rates Exist
Factor rates are common in alternative lending for several reasons:
- Simplicity: Easy for borrowers to understand total repayment
- Higher risk borrowers: Compensates lenders for elevated default risk
- Speed of funding: Simplified underwriting enables same-day funding
- Revenue-based repayment: Pairs with percentage-of-sales collection
- Regulatory arbitrage: Some factor products avoid lending regulations
Cost Comparison Example
Compare the same $50,000 borrowed under each method:
| Method | Quoted Rate | Term | Total Repaid | Effective APR |
|---|---|---|---|---|
| Simple interest | 10% APR | 12 months | $55,000 | 10% |
| Compound (monthly) | 10% annual | 12 months | $55,236 | 10.47% |
| Factor rate | 1.25 factor | 12 months | $62,500 | ~50% |
Daily Interest Calculation
Most business loans calculate interest daily. Here is how:
- Daily rate: Annual rate / 365 (or 360 for some lenders)
- Daily interest: Outstanding balance x daily rate
- Example: $100,000 x (10% / 365) = $27.40 per day
- Monthly accrual: Approximately $833 in interest per month initially
365 vs 360 Day Year
Some lenders use a 360-day year for calculations, which slightly increases your effective rate. Ask which convention your lender uses.
Questions to Ask About Interest
Before signing, clarify these points:
- [ ] Is this simple interest or compound?
- [ ] If factor rate, what is the equivalent APR?
- [ ] How is daily interest calculated (365 or 360 days)?
- [ ] Is there a prepayment discount?
- [ ] At what point does interest stop accruing?
- [ ] Are there any interest rate adjustments during the term?
Choosing Based on Interest Method
General guidance:
- Simple interest: Best choice when available, rewards prepayment
- Compound interest: Acceptable for credit lines where balance fluctuates
- Factor rate: Consider only if you need very fast funding and cannot qualify elsewhere
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Read more →What is a Factor Rate?
Understanding factor rates used in merchant cash advances and short-term business loans, including how to convert them to APR for accurate comparison.
Read more →How to Compare Multiple Business Loan Offers Side by Side
Learn how to evaluate and compare business loan offers by examining APR, total cost, fees, terms, and repayment structure to choose the best financing option.
Read more →Important Disclosure
Not Financial Advice: The information provided in this article is for general informational purposes only and does not constitute financial, legal, or professional advice. You should consult with qualified professionals before making any financial decisions.
No Guarantee of Financing: Liminal Lending Co. is a business loan marketplace that connects borrowers with third-party lenders. We are not a lender and do not make credit decisions. Submitting an application does not guarantee approval or funding. Loan terms, rates, and availability vary by lender and are subject to borrower qualifications and lender criteria.
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Rate Information: Rates, terms, and fees mentioned in this article are estimates based on publicly available information and may not reflect current market conditions or specific lender offers. Actual rates depend on creditworthiness, business financials, and lender policies.
Information May Change: Financial markets, lending regulations, and economic conditions are subject to rapid change. While we strive to keep our content accurate and up-to-date, information in this article may become outdated. Always verify current rates, terms, program availability, and regulatory requirements with lenders and official sources before making financial decisions.