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Annual Percentage Rate
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Annual Percentage Rate or (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 the rate is expressed. In other words the APR is the total cost of credit to the consumer expressed as an annual percentage of the amount of credit granted. APR is intended to make it easier to compare lenders and loan options. The APR is likely to differ from the "note rate" or "headline rate" advertised by the lender. The concept of APR can be generalized. For example lenders use the same concept to calculate their total earnings on loans and for determining their margin on the loan. Consumers can use the APR concept to compare savings accounts and calculate the earnings on a savings account, taking transaction costs into account. In the US and the UK, lenders are required to disclose the APR before the loan (or credit application) is finalized. APR is a term used with regards to deposit accounts as well. However, when dealing with deposit accounts, Annual Percentage Yield APY or Annual Equivalent Rate AER is the number to be quoted to consumers for comparison purposes. |
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Rates
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An effective
annual interest rate of 10% can also be expressed in several ways:
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Pitfalls
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| 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. Does not represent the total cost of borrowing. Credit card holders should be aware that most US credit cards are quoted in terms of nominal APR compounded monthly, which is not the same as the effective annual rate (EAR). Despite the "Annual" in APR, it is not necessarily a direct reference for the interest rate paid on a stable balance over one year. The more direct reference for the one-year rate of interest is EAR. The general conversion factor for APR to EAR is EAR=((1+APR/n)^n)-1, where n represents the number of compounding periods of the APR per EAR period. E.g., for a common credit card quoted at 12.99% APR compounded monthly, the one year EAR is (1+.129949/12)^12-1, or 13.7975% (see Credit card interest for the .000049 addition to the 12.99% APR). Note that a high US APR of 29.99% carries an effective annual rate of 34.48%. While the difference between APR and EAR may seem trivial, because of the exponential nature of interest these small difference can have a large effect over the life of a loan. For example, consider a 30-year loan of $200,000 with a stated APR of 10.00%, i.e., 10.0049% APR or the EAR equivalent of 10.4767%. The monthly payments, using APR, would be $1755.80. However, using an EAR of 10.00% the monthly payment would be $1691.78. The difference between the EAR and APR amounts to a difference of $64.09 per month. Over the life of a 30-year loan, this amounts to $23,070.90, which is over 11% of the original loan amount. Some classes of fees are deliberately not included in the calculation of APR. 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: (1) routine one-time fees which are paid to someone other than the lender (such as a real estate attorney's fee) (2)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, for example, is 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 part of the loan. Consumer advocates argue that this would be true 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 by the practice of contingency fees - for example, when the lender receives money from the attorney and other agents to be the one used by the lender. Because of this, US regulators require all lenders to produce an affiliated business disclosure form which shows the amounts paid between the lender and the appraisal firms, attorneys, etc. 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. |
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