Understanding APR And AIR

Written by Bryan Daly
Fact-checked by Caitlin Wood

Understanding APR And AIR

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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.

What Is AIR?

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:

Total Interest ÷ Loan Amount ÷ Length of Repayment Term

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.

What Is APR?

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:

Loan’s periodic interest rate (rate charged per month)
Total loan principal
Size of your monthly loan payments
Number of days in your repayment term
Fees and interest charged over the life of the loan
Any discounts that can be applied

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.

How To Calculate AIR Vs APR

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:

Calculating AIR

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:

$5,000 of interest on a $50,000 personal loan, with a 2-year term
$5,000 ÷ ($50,000 ÷ 2) = 0.05 or 5.00% AIR

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.

Calculating APR

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

Add the total number of fees and interest together
Divide that by the loan principal and the number of days in your term
Multiply that amount by 365 to determine your annual rate
Multiply that amount by 100 to switch your annual rate to a percentage

(($550 + $5,000) ÷ $50,000 ÷ 730) x 365 x 100 = 5.55% APR
According to these figures, your monthly payment should be $2,206

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.

Additional Reading

What’s More Important: Lower Fees (APR) Or A Lower Yearly Rate (AIR)?

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:

AIR – Your Annual Interest Rate produces more accurate results than APR when calculating your yearly interest rate and the initial size of your monthly payments. It fluctuates according to your lender’s current rates, as well as your financial health. The stronger your income and credit are, the lower your rate will be.

APR – While your Annual Percentage Rate offers a broader percentage that’s set by the lender, it’s a simpler way of calculating the yearly cost of loan, as it takes other factors into account, including discounts and fees. By law, all lenders must display their APR (but not necessarily all their fees) on their loan agreements.

Learn how to pay off your high interest debt.

Why Does The Length Of Your Loan Term Matter?

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:

High APR & Low AIR – Generally, a shorter repayment term leads to a higher APR because the lender has to maximize profit over a shorter period. However, loans with higher APRs often come with fewer upfront fees. This way, you might have a lower AIR overall (especially if you pay off your loan ahead of schedule).

Low APR & High AIR – Many borrowers opt for longer repayment terms, which come with lower rates and sometimes discount points. That said, longer terms result in extra labor for the lender, meaning additional fees (APR) will apply. Although you’ll have smaller monthly payments, your AIR will be higher.

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

Final Notes

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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Bryan Daly

Bryan is a graduate of Dawson College and Concordia University. Bryan has been working for Loans Canada for five years and covers a wide range of topics, including credit improvement, debt management, and all things related to personal finance. In his spare time, he maintains a passion for editing, writing film and television screenplays, staying fit, and traveling the world in search of the coolest sights our planet has to offer. He aims to pursue the craft of professional writing for many years to come.