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:

1. Total the included one-time costs and add them to the face amount on the loan
2. Calculate a monthly payment for that amount at the loan's "note rate"
3. 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 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, the government has made all lenders produce an affliated 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.

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 home mortgage loan, the following kinds of fees are:

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

• nominal interest rate

External Links

• a mortgage APR calculator
• The US Office of the Comptroller of Currency's downloadable APR calculator (Note: please read the disclaimer)
• a generalized APR calculator