Consumer Credit: What Is An Apr?

Lenders are required by federal law to disclose all costs incurred with a loan. The APR is the measure of the actual cost of credit.

Before the passage of the Federal Truth in Lending Act, it was very hard for consumers to comparison shop for the best deal when applying for credit. While creditors have always advertised their fixed interest rates, they did not always disclose other charges and fees that may have been associated with the loan. As a result, many consumers were blindsided with surprise charges. The government realized that it had to do a better job of protecting consumers from these unpleasant surprises. The Federal Truth in Lending Act required all financial institutions, mortgage companies, credit card companies and other companies to disclose all costs incurred with a loan. The APR system was then developed to accurately measure these costs.

APR stands for Annual Percentage Rate. APR's are calculated by a using a standard formula, the final percentage being expressed in an annual interest rate. When calculating the APR, any interest, points, origination fees, insurance, appraisal fees, processing fees and any other charges are taken into consideration. The total amount of all these fees is commonly referred to as the finance charge. Many of these charges were not disclosed to consumers before this law was put in place, and many people mistakenly assumed the only costs associated with the loan would be their fixed interest rate. It also made it difficult to look for the best deal when applying for credit because these fees were not always stated upfront.

In order to understand what the APR means for the consumer, it is important to know how APRs are calculated. The most common and accurate method for calculating the APR is the actuarial method, which is also the method most likely to be used by lenders. The actuarial method calculates interest computed on unpaid balances of the principal (the outstanding balance of the loan not including interest or other charges). To illustrate, let's say you get two mortgage offers with two different banks. You are approved for $100,000. Bank A offers you a fixed interest rate of 7%, while Bank B offers you a fixed interest rate of 8%. On first glance, many people would go with the 7% rate, thinking Bank A is offering the better deal. However, what Bank A didn't tell you was that there was a 3% origination fee, a $500 processing fee, and mortgage insurance that the bank is requiring you to purchase. What first looked like a bargain is actually going to cost you thousands more.

This is why APR disclosure is so important. When determining the Annual Percentage Rate, all of those costs mentioned earlier will be subtracted from the original loan amount. This remaining balance is then compared to your monthly payments. The result? The consumer gets a better picture of the actual cost of credit.

Bank B, on the other hand, only charges a 1% origination fee, and a $150 processing fee. Additionally Bank B is not requiring you to buy mortgage insurance. So while Bank A has a lower fixed interest rate than Bank B, the APR will actually be higher. Therefore, Bank B is really the better deal. APRs serve as a protection for consumers who may not be properly notified of accidental fees associated with the loan.

While APRs provide a very important piece of information, it is important to look at other factors as well. Keep in mind that the more money you apply for, the less affect extra charges will have on the APR. Additionally, the longer the term of the loan, the lower the APR. It is also important to know that fees that are not being charged by the bank (such as title and escrow fees) will not be used to calculate the APR.

Simply put, the APR is the ratio of all interest and finance charges to the amount of credit you are receiving. Knowing Annual Percentage rates beforehand allows the consumer to compare credit offers on fair and equal terms. It also serves as a protection against predatory lenders who charge excessive fees. The best advice for consumers is to not be fooled by low monthly payments or a too-good-to-be-true interest rate. Make sure you look at the APR as well.

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