Annual percentage rate

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Annual Percentage Rate (APR) is an expression of the effective interest rate that will be paid on a loan, taking into account one-time fees and standardizing the way this rate is expressed. The APR is likely to differ from the "note rate" or "headline rate" advertised by the lender. The aim of using APR is to calculate a total cost of borrowing which allows easy comparison between loans and lenders.

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.

Contents

1 APR's successes

1.1 Other costs
1.2 Comparison
1.3 Rate format

2 APR's failings

2.1 APR cannot represent the total cost of borrowing
2.2 Loan retention assumed to equal loan pay-back period
2.3 APR cannot result in a comparable standard
2.4 Non-repeatability

3 Region-specific details

3.1 UK
3.2 USA
3.3 European Union

4 See also

APR's successes

Other costs

In a simplified example, if you borrow $100 for one year at 5% interest (so 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 ($5 in a year for interest plus $5 now for the origination fee). Your APR will come out at just less than 10%.

Comparison

APR is intended to make it easier to compare lenders and loan options. In the US and the UK, lenders are required to disclose the APR before the loan (or credit application) is finalized.

Rate format

An effective annual interest rate of 10% can also be expressed in several ways:

0.7974% effective monthly interest rate
9.569% annual interest rate compounded monthly
9.091% annual rate in advance.

These rates are all equivalent, but to a consumer who is not trained in the mathematics of finance, this can be confusing. APR helps to standardize how interest rates are compared, so that a 10% loan is not made to look cheaper by calling it a loan at "9.1% annually in advance".

APR's failings

Despite repeated attempts by regulators to establish usable and consistent standards, APR does not represent the total cost of borrowing nor does it really create a comparable standard. Nevertheless, it is considered a reasonable starting point for an ad-hoc comparison of lenders.

APR cannot represent the total cost of borrowing

Some classes of fees are deliberately not included in the calculation. Because these fees are not included, some consumer advocates claim that the APR does not represent the total cost of borrowing. Excluded fees may include:

routine one-time fees which are paid to someone other than the lender (such as a real estate attorney's fee)
penalties such as late fees or service reinstatement fees without regard for the size of the penalty or the likelihood that it will be imposed.

Lenders argue that the real estate attorney's fee is an example of a pass-through cost, not a cost of the lending. In effect, they are arguing that the attorney's fee is a separate transaction and not a cost of lending. This is true if the attorneys fees are the same everywhere, or if the customer is free to select which attorney is used. If the lender insists on using a specific attorney however, then the cost should be looked at as a component of the total cost of doing business with that lender. This area is made more complicated due to the practice of the lender receiving money from the attorney and other agents to be the one used by the lender. Because of this, in the United States, the government has made all lenders produce an affiliated business disclosure form, which shows the amount paid by the lender to things like appraisal firms and attorneys.

Lenders argue that including late fees and other conditional charges would require them to make assumptions about the consumer's behavior—assumptions which would bias the resulting calculation and create more confusion than clarity.

Loan retention assumed to equal loan pay-back period

Another problem with the APR calculation is the assumption that an individual will keep a particular mortgage loan until it is completely paid off resulting in the up-front fixed closing costs being amortized over the full term. The usual pay-back periods are 30 and 15 years but how many people keep the same mortgage that long? Not many, because the odds someone will either refinance or move before the loan is paid off are very high. Computing the APR over the full loan term deflates the apparent cost of the loan, making it harder to decide if it truly makes sense to refinance an existing mortgage. An APR calculator should allow the user to enter a loan retention period or time-in-loan period to more fully gauge the cost of the up-front fixed closing costs.

APR cannot result in a comparable standard

Regulators have been unable to completely define which one-time fees must be included and which excluded. This leaves the lender with some discretion to determine which fees will be included (or not) in the calculation.

In the example of a mortgage, the following kinds of fees are:
Generally included:
Points
Pre-paid interest
Origination fees including loan processing, underwriting and document preparation
Attorney and Notary fees
Closing Agent's document preparation fees
PMI (private mortgage insurance)
Sometimes included:
Application fees
Life insurance
Generally not included:
Appraisal
Home-inspection
Credit report costs
Title fee
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.

Region-specific details

UK

APR was introduced under the Consumer Credit Act 1974, to ensure comparability of loans - and is required to be published for all loans.

[Detailed explanation of the UK calculation]
The [consumer guide to credit charges and APR] from the Office of Fair Trading
The [APR and rebate calculator] from the Office of Fair Trading

USA

European Union

A single method of calculating the APR was introduced in directive 98/7/EC and is required to be published for the major part of loans.

[directive 98/7/EC with mathematical formula]