Annual Percentage Rate (APR)
What it is:
How it works (Example):
There are at least three ways of computing effective annual percentage rate.
1) Compound the interest rate for each year, without considering fees.
2) Add fees to the balance due, making the total amount the basis for computing compound interest.
3) Amortize the fees as a short-term loan. This loan is due in the initial payments. The remaining unpaid balance is amortized as a second, longer-term loan.
Though the APR can be calculated in several ways depending on the terms of the loan, the formula which includes the basic components is:
APR = [2 x Number of Payments per Year x Total Finance Charges] / [Original Loan Proceeds x Total Number of Payments + 1]
Why it Matters:
Lenders offer a multitude of interest-rate structures, fees, private mortgage insurance and points. Knowing a loan's APR tells the borrower what the true cost of borrowing is because it includes all of the fees directly related to the loan, not just the interest payments.
The responsibility of calculating APRs falls on the lender, not the borrower. Federal regulations require lenders to disclose a loan's APR in large type and the Consumer Credit Protection Act of 1968 (also known as the Truth in Lending Act) requires lenders to disclose a loan's finance charges as well as its APR so that borrowers may compare loans in a clearer format.
The fact that there is more than one way to calculate an APR complicates the comparison.
APR calculations are based on fixed interest rates so adjustable rates create ever-changing APRs. It is important that a borrower compare loans with identical maturities. A shorter loan could have a lower interest rate but a higher APR because the loan fees amortize over a shorter period of time.
For these reasons, some borrowers turn to good faith estimates from lenders to compare loan fees directly rather than compare the APRs.