When you are shopping for loans online, you will find that some vendors prefer to sell their loans by highlighting the AIR (Annual Interest Rate) they offer on their products, as opposed to the traditional APR (Annual Percentage Rate).
It is important that you understand the difference between these two rates. After all, only a full understanding of these rates will allow you to decide whether or not you can repay a loan comfortably, whether the loan is reasonably priced and also which one of two or more loans is the more cost-effective choice for you.
AIR is almost always lower than APR
The thing with AIR is that it includes only the interest rate charged by the lender. It essentially gives you a percentage rate that you can use to calculate how much you will pay every month.
But, that alone doesn’t tell the whole picture when it comes to pretty much any type of loan. Because, loans typically carry a variety of fees such as origination fees, application fee, closing fees and a few other potential fees like broker fees, etc, fees that will all add to the borrowing cost of the borrower.
A lender who advertises their loans with APR will not necessary charge you more than a lender who advertises their loan products with AIR. Why? Because most of the fees required by the lender who uses APR are fees that are received upfront.In other words, they can first receive these fees from you and then charge you the same monthly payment that the lender who advertises with AIR does. In some cases, the lender using APR will not explicitly take money as fees from you. Instead, they will deduct such fees from the loan amount that is payable to you. That is a bummer too!
But, what you must importantly understand is that APR reflects the true cost of your loan better than AIR. If you are paying fees to receive a loan, you can’t just turn a blind eye to those costs that make up for the difference between AIR and APR! It will have to be brought into your feasibility analysis in some way or another.
What is more important to you? Monthly payment or total cost of loan?
Whether you use AIR or APR will usually depend on the philosophy with which you look at repaying a loan with. Most people will only look at what they can afford to pay back every month. As long as their monthly payment is affordable, they don’t really want to delve into the details of the cost of the loan.
Then, there are other borrowers who are a bit more picky and savvy. Not only do they want their monthly payment to be affordable, they also want the total cost of their loan to be affordable as well. Such people will intently focus on the APR rather than AIR.
It is advisable that you also focus on APR, no matter what your needs, so you borrow at a reasonable cost and not just borrow because you can afford the monthly payment.
It is particularly helpful when comparing two loans to choose from, especially when loans being compared have different fee formats that can make comparisons difficult. When shopping for loans, it is often possible for a lender to require you to pay a smaller monthly payment than another lender. But this doesn’t always mean that the loan with the lower monthly payment is a cheaper loan.
If said lender charges exorbitant origination fees, broker fees, closing fees and what not, the total cost of the loan might actually be much higher than a lender who requires a higher monthly payment!
Even APR is not the gold standard
By now, you have probably come to understand that APR is the go to measure to evaluate the cost of the loan, right? Unfortunately, even APR isn’t perfect. The reason why we stressed so much about APR in the preceding passages was to get you to understand that APR is at least better than AIR, and that you should at least consider evaluating it.
But now, why APR is also not a perfect measure of a cost of a loan is because there are different regulations on what sort of fees “HAVE” to be included in an APR and what can be optionally left out.
When there is an option to leave out fees, lenders can start to act a little funny. By federal law, APR needs to include origination fees, administrative fees, title fees, closing costs, insurance premiums, prepaid interest, application fees and tax related fees. But, fees like appraisal fees, credit report fees, title fees and the really weird ones like recording fees can be conveniently left out. While the fees marked not mandatory to be reported in APR may not typically amount to much, they do defeat the purpose of presenting the “true cost” of the loan.
You must also carefully look at the closing date of a loan to understand the true impact of the APR.
So now that you understand the difference between AIR and APR, we hope you will put it to good use when shopping around for your next loan!