Annual Interest Rate (AIR) - How and Why It's Used
There are many ways to communicate the rate of a business loan. This can create some confusion, but each approach has its purpose. Today, we'll be going over the Annual Interest Rate (AIR), one way to understand the interest you’ll pay on a loan.
What is the Annual Interest Rate?
The AIR is the average amount of interest (expressed as a %) you pay each year on a loan. It is calculated by taking the total interest and dividing it by the loan amount and number of years borrowed. For example, if you get a $100,000 loan for 1 year with a total interest cost of $10,710, the calculation would be $10,710 / ($100,000 / 1) = 10.7% AIR.
Please keep in mind that this does not factor in fees or if you decide to pay your loan off early to save on interest.
Why are Annual Interest Rates Used?
Many small business owners find the traditional way of calculating the rate (APR) helpful in comparing loans, but misleading when understanding their actual cost. This is especially true with declining balance loans.
For example, the same $100,000 loan we used in the previous example would have an APR of roughly 19.99%. A common mistake is thinking that this means $19,990 in interest will be paid, but that isn't true. With a declining balance loan, you are only charged interest on the outstanding principal each time you make a payment. This means your actual interest cost (as a percentage of the loan amount) will be roughly half of the stated APR. In this graphic, you can see how the outstanding principal (and the interest paid) decreases over time:
Some lenders, especially alternative lenders who offer short-term loans, have recognized this issue and now communicate the AIR. However, the APR is still helpful when comparing loans and should be included in your loan agreement.
What Really Matters?
Make sure you are comfortable with the answers to these questions before deciding which loan to get:
- How much will it cost? - Your lender should be transparent about the cost of their loan. This means not only sharing the rate, but also the amortization schedule and breakdown of the fees.
- Can you afford it? - It’s important to know you have enough cash flow to be able to handle the loan payments.
- How much money will you make? - Too many business owners only focus on cost. Make sure you are getting a positive return on your investment and minimizing your opportunity costs.
- Are you improving your credit position? - You always want to improve your credit whenever possible. Make sure you are able to spot when a lender is offering you a Merchant Cash Advance, which isn't a real business loan and won't allow you to build your business credit.
- Can you pay your loan off early without penalty? - You shouldn't be penalized for making an investment that is so successful that you no longer need the loan. Watch out for lenders who disguise their penalties as a "discount on the remaining interest owed".