Annual percentage rate
Annual Percentage Rate (APR) is an expression of the effective interest rate that will be paid on a loan. It is different from the "note rate" (the advertised interest rate) because it includes one-time fees in an attempt to calculate a "total cost" of borrowing money.
In a simplified example, if you borrow $100 for one year at 5% simple interest (meaning that you will owe $105 at the end of the year) and you pay the lender a $5 origination fee, your total cost to borrow the money will be $10 and your APR is about 10%.
APR is intended to make it easier to compare lenders. In the US, lenders are required to disclose the APR before the loan (or credit application) is finalized.
While there are several acceptable ways to calculate the exact APR, the general process is:
- Total the included one-time costs and add them to the face amount on the loan
- Calculate a monthly payment for that amount at the loan's "note rate"
- Calculate what interest rate would have to be applied to just the face amount of the loan in order to equal the calculated monthly payment in step 2.
APR's failings
Despite repeated attempts by home mortgage loan, the following kinds of fees are:
| Generally included: | Sometimes included: | Generally not included:
|
Points
Pre-paid interest
Origination fees including loan processing, underwriting and document preparation
PMI (private mortgage insurance)
| Application fees
Life insurance
| Appraisal
Home-inspection
Credit report costs
Title fee
Attorney and Notary fees
Closing Agent's document preparation fees
|
The discretion that is illustrated in the "sometimes included" column even in the highly regulated home mortgage environment makes it difficult to simply compare the APRs of two lenders. Note: US regulators generally require a lender to use the same assumptions and definitions in their calculation of APR for each of their products even though they cannot force consistency across lenders.
In addition to the difficulties of determining what fees to include or exclude, APR is dependent on the time period for which the loan is calculated. That is, the APR for one loan with a 30 year duration loan cannot be compared to the APR for another loan with a 20 year loan duration. APR can be used to show the relative impact of different payment schedules (such as balloon payments or bi-weekly payments instead of straight monthly payments), but most standard APR calculators have difficulty with those calculations.
Non-repeatability
Two lenders with identical information may still calculate different APRs. The calculations can be quite complex and are poorly understood even by most financial professionals. Most users depend on software packages to calculate APR and are therefore dependent on the assumptions in that particular software package. While differences between software packages will not result in large variations, there are several acceptable methods of calculating APR, each of which returns a slightly different result.
See also
External Links
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