A Guide to Understanding APRs

Before the Federal Truth in Lending Act was passed, it was quite difficult for consumers to understand all of their options when applying for a loan. While banks were always required to provide information regarding their fixed interest rates, they were not always as forthcoming when it came to disclosing other fees or charges that were often associated with the loan. After the Federal Truth in Lending Act was passed, banks and other lending institutions were required to disclose all of the fees and charges associated with a loan. To assist in complying with this law, the APR system was developed. The APR, or Annual Percentage Rate, helps to accurately measure all of the costs that are associated with a loan.

Your APR is calculated using a standard formula, which is then expressed as a percentage of an annual rate. All fees, interest and other charges are factored into the equation. When all these fees are added together, the sum is referred to as a finance charge. The actuarial method is the most popular and accurate method for calculating your APR. The actuarial method is calculated by computing on the outstanding balance of the actual loan amount.

APR disclosure is important because it gives the consumer a more accurate picture of the actual cost of the credit that is being extended to him or her. When calculating the Annual Percentage Rate, any incidental charges are subtracted from the original loan amount. The remaining amount is then compared to any monthly payments that you may have.

For example, you may have received two mortgage loan offers from two different lenders. Each lender approves you for $100,000. The first lender is offering a fixed interest rate of 5% while the second lender is offering 6%. While the first lender is offering a lower interest rate, that does not necessarily mean that it is the better deal. If the first lender has excessive origination fees, processing fees and mortgage insurance that they are requiring you to take out, their mortgage will actually end up costing you thousands of dollars more. This is taken into consideration with determining the APR. While the first lender has a lower interest rate, it will have a higher APR than the second lender.

When you are comparing the APRs of different lenders, there are some important things that you may want to consider. The larger the dollar amount of the loan, the smaller the impact extra charges will have on APR. In addition, the APR may appear to be lower if the term of the loan is longer. In the case of mortgage loans, it is also important to keep in mind that non-bank related charges like escrow and title fees are not used to calculate the APR, so it is important that you have money set aside for these expenses.  

The APR gives you a snapshot ratio of all of the interest and finance charges to the actual amount of credit you receive. Knowing how to properly analyze and compare APRs gives the consumer a vital piece of information and protects them from predatory lenders, who are notorious for charging excessive fees.