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There are two different terms associated with the yearly interest rates that are applied to your debts, annual percentage rates (APR) and annual interest rates (AIR). Interest can be hard to understand but with some general knowledge on how it’s calculated and how it’s applied to your debts, you’ll be more successful in managing your money.
Short for “Annual Interest Rate”, AIR refers to the estimated amount of interest that you would pay yearly to borrow a specific amount of loan principal, like you would see with a personal loan or mortgage. Your AIR is displayed as a fixed or variable percentage and lenders will typically calculate it using this equation:
While most lenders use Annual Percentage Rate (APR) when comparing the cost of different loan products, it doesn’t always produce as accurate of a figure as Annual Interest Rate (AIR) does, particularly when it comes to installment-based loans.
Otherwise known as a “declining balance loan”, installment loans involve a set sum, which gets lower whenever you make a payment. Your lender should only charge interest on the balance that remains. If your rate is “fixed”, it won’t change throughout your loan term and if it’s “variable”, it fluctuates with Canada’s prime borrowing rates.
To truly understand AIR, you must also learn about APR or Annual Percentage Rate, which is the annual interest rate that lenders charge you to borrow from them. It’s charged on a yearly basis as a percentage of your loan principal.
Unlike AIR, however, APR is calculated using different criteria, such as the:
Formula: ((Fees + Interest) ÷ (Principal) ÷ (# of Days in Term) x 365) x 100
There are several types of APR that lenders apply to different financial products, like credit cards, cash advances and lines of credit. APR is also used on investment accounts to determine the annual rate an investor earns without compounding interest.
Remember, the Annual Interest Rate (AIR) is the percentage of the loan principal that a lender charges you yearly to borrow funds from them. Annual Percentage Rate (APR) is similar, in that it uses the total amount of interest that you have to pay each year, only it encompasses all costs involved with the loan. Here are a couple of basic examples:
As mentioned, your Annual Interest Rate is calculated by taking the total yearly interest your lender charges you, dividing it by your loan amount, then dividing that number by the length of your repayment term. Let’s say that you have:
Keep in mind that this is just a simplified way of calculating someone’s Annual Interest Rate. When your lender actually assigns your AIR, their decision will be based on other factors, like your income, credit score and debt level. The better your financial health is overall, the less risk you have of defaulting on your loan payments in the future. As a result, the lender may offer you a larger loan with a lower AIR and a longer term.
To give you a better idea of how Annual Percentage Rate works, let’s apply the formula shown above to the same example (a $50,000 loan with $5,000 interest and a 2-year term), only this time we’ll add a 1% ($550) origination fee to make it more realistic:
Formula: ((Fees + Interest) ÷ (Principal) ÷ (# of Days in Term) x 365) x 100
Essentially, while AIR reflects your yearly interest rate, APR may show the true cost of borrowing, since it factors in all the costs associated with your loan/credit product. The length of your loan term also matters greatly, because a longer term generally leads to a lower APR. Plus, there’s always the chance that you manage to pay your loan off early.
As you can see, the Annual Percentage Rate is slightly higher than the Annual Interest Rate above. However, don’t forget that your loan balance will be “declining” and your lender should only charge you interest on the unpaid principal remaining. Due to this confusion, many lenders have started using AIR to calculate the true cost of a loan.
Find out more on how to avoid high interest loans.
These days, most lenders will use a combination of AIR and APR to tally up the total cost of your loan. Then again, there are specific circumstances where either type of rate could be considered “better” than the other. For instance:
Learn how to pay off your high interest debt.
So, when you take out a loan, is it better to have a lower AIR with a higher APR or a higher AIR with lower APR? The answer can depend on a number of things, one of the most significant being the length of your repayment term. Here are two more examples:
To see how the length of your loan term affects your APR and AIR, check out the table below. Once again, we’ll use the same $50,000 personal loan with a 1% origination fee, only we’ll change up the interest rates and add $1,000 in extra fees per 5 year block.
Loan Amount | $50,000 | $50,000 | $50,000 |
Loan Term | 5 years | 10 years | 15 years |
Interest Rate | 5.50% | 5.00% | 4.50% |
APR | 6.73% | 6.58% | 6.56% |
Estimated Fees | 1% + $1,000 = $1,500 | 1% + $2,000 = $2,500 | 1% + $3,000 = $3,500 |
Monthly Payment | $955.06 | $542.63 | $408.54 |
Total Principal | 60 x $955.06 = $57,303.60 | 120 x $542.63 = $65,115.60 | 180 x $408.54 = $73,537.20 |
Interest rates and APR/AIR might seem like complicated financial terms that have no effect on you or your money, but in reality they affect most aspects of your financial life. For example, you can use your APR/AIR to your advantage when deciding what credit card to pay off first. Always go with the card that has the highest APR/AIR, as those will accumulate interest quicker. Inform yourself on interest rates and other financial terms, and your finances will thank you later.
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