There are a number of factors we consider when we take a loan. One of the key considerations is the rate of interest a lender offers. We usually take into account the advertised interest rate, which is what we believe we will pay for the loan. In fact, this is only the base rate and does not take into account other costs involved in taking a loan.
This is why every business owner must find out the different rates of interest applicable to a loan product. It serves as a way to understand the actual costs beforehand and strategize accordingly. It also helps to know whether the business will be able to meet the loan obligations or not.
Most financial institutions tend to advertise the base rate or Annual Interest Rate (AIR) that does not include the costs and other charges of borrowing. Therefore, a standardised computation process such Annual Percentage Rate (APR) is followed to know the actual cost of borrowing before taking the loan.
Therefore, let us understand the two widely used interest calculation methods, annual interest rate and annual percentage rate and how they are used.
What is Annual Interest Rate?
The Annual Interest Rate is the basic interest rate and does not reflect any fees or the effect of compounding interest. Therefore, the final interest rate amount is always higher compared to the quoted AIR.
AIR is just the average amount of interest paid on a loan and is calculated by dividing the total interest by the principal amount and then by the loan tenure.
For example: For a loan of Rs 10 lakh for a 2 year tenure, the total interest will be Rs 1.8 lakh. The calculation for AIR will be as follows:
AIR = [(1,80,000/ 10,00,000)/2]100 = 9%
How is Annual Interest Rate helpful?
Though AIR does not give a clear understanding of the final cost of a loan, it is helpful while calculating interest on declining balance loan. Also, it helps in the initial comparison of the loan product, as it forms the major part of the total cost of the loan.
What is Annual Percentage Rate?
Annual Percentage Rate represents the actual cost of the loan over the tenure of the loan. The calculation of APR includes fees and all other associated costs but does not take compounding into consideration.
In simple words, APR is the combination of nominal interest rate and other costs involved in getting the loan. APR provides borrowers with more realistic data on the cost of the loan, which helps to compare various loan products. It is calculated using the following formulae:
APR = [{(Fees + Interest)/ Principal}/ n]*365*100
n = no. of days in the loan term
For example, for a loan amount of Rs 10 lakh with interest cost of Rs 1.8 lakh and processing fee coming at Rs 35,000, the APR would be:
APR = [{(1,80,000+ 35,000)/10,00,000}/730]*365*100 = 10.75%
Why is Annual Percentage Rate important?
In general, AIR does not reveal the actual cost of the loan since it does not factor in fees and other charges. But, all such costs play a major role in determining the total cost of the loan.
Sometimes a lender may offer a lower AIR to attract customers but keep all other costs high. This results in concealment of the actual cost of the loan. For example, the APR is useful when multiple lenders offer the same AIR on their loan products. Thus, APR helps you find the true cost of the loan and get the best deal.
However, APR also has certain drawbacks since the calculation is based on a fixed interest rate. Therefore, when it comes to variable interest rate, it can truly undermine the actual cost of borrowing. Further, APR is best used to compare long-term loans that span over 10 years or more.
Conclusion
Using the APR method over the AIR method will give you a better idea of the actual cost of the loan while AIR will help you calculate the interest on a declining loan balance.
It is imperative to understand the various interest rates to get a fair idea of the hidden costs of taking a loan. This will help you select the most suitable loan product and manage your business finances in an efficient way.
