Annual percentage rate
Encyclopedia
The term annual percentage rate (APR), also called nominal APR, and the term effective APR, also called EAR, describe the interest rate for a whole year (annualized), rather than just a monthly fee/rate, as applied on a loan
, mortgage loan
, credit card
, etc. It is a finance charge expressed as an annual rate. Those terms have formal, legal definitions in some countries or legal jurisdiction
s, but in general:
The nominal APR is calculated as: the rate, for a payment period, multiplied by the number of payment periods in a year. However, the exact legal definition of "effective APR", or EAR in short, can vary greatly in each jurisdiction, depending on the type of fees included, such as participation fees, loan origination
fees, monthly service charges, or late fee
s. The effective APR has been called the "mathematically-true" interest rate for each year.
The computation for the effective APR, as the fee+compound interest
rate, can also vary depending on whether the up-front fees, such as origination or participation fees, are added to the entire amount, or treated as a short-term loan due in the first payment. When start-up fees are paid as first payment(s), the balance due might accrue more interest, as being delayed by the extra payment period(s).
In some areas, the annual percentage rate (APR) is the simplified counterpart to the effective interest rate
that the borrower will pay on a loan. When not using the term "effective APR", the use of "APR" is an early term for nominal APR. In many countries and jurisdictions, lenders (such as banks) are required to disclose the "cost" of borrowing in some standardized way as a form of consumer protection
. 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, due to the addition of other fees that may need to be included in the APR. APRs can be found by asking the lender or by reading the appropriate section in the contract.
In the U.S.
and the UK
, lenders are required to disclose the APR before the loan (or credit application) is finalized (although the definition of "APR" is not the same in the two countries-–see below). Credit card companies can advertise monthly interest rates, but they are required to clearly state the annual percentage rate before an agreement is signed. APR is a term used with regard to deposit accounts as well. However, when dealing with deposit accounts, the annual percentage yield
(APY) or annual equivalent rate (AER) is quoted to consumers for comparison purposes.
For example, consider a $100 loan which must be repaid after one month, plus 5%, plus a $10 fee. If the fee is neglected, this loan has a (year-long) effective APR of approximately 79% (
). If the $10 fee were considered, the monthly interest increases by 10% ($10/$100), and the effective APR becomes approximately 435% (
, as 535%-100%=435%). Hence there are at least two possible "effective APRs": 79% and 435%. Laws vary as to whether fees must be included in APR calculations.
the APR is used to find compound and simple interest rates.
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".
The APR does not necessarily convey the total amount of interest paid over the course of a year: if one pays part of the interest prior to the end of the year, the total amount of interest paid is less.
In the case of a loan with no fees, the amortization schedule
would be worked out by taking the principal left at the end of each month, multiplying by the monthly rate and then subtracting the monthly payment. This can be expressed mathematically by
This also explains why a 15 year mortgage and a 30 year mortgage with the same APR would have different monthly payments and a different total amount of interest paid. There are many more periods over which to spread the principal, which makes the payment smaller, but there are just as many periods over which to charge interest at the same rate, which makes the total amount of interest paid much greater. For example, $100,000 mortgaged (without fees, since they add into the calculation in a different way) over 15 years costs a total of $193,429.80 (interest is 93.430% of principal), but over 30 years, costs a total of $315,925.20 (interest is 215.925% of principal).
In addition the APR takes costs into account. Suppose for instance that $100,000 is borrowed with $1000 one-time fees paid in advance. If, in the second case, equal monthly payments are made of $946.01 against 9.569% compounded monthly then it takes 240 months to pay the loan back. If the $1000 one-time fees are taken into account then the yearly interest rate paid is effectively equal to 10.31%.
The APR concept can also be applied to savings accounts: imagine a savings account with 1% costs at each withdrawal and again 9.569% interest compounded monthly. Suppose that the complete amount including the interest is withdrawn after exactly one year. Then, taking this 1% fee into account, the savings effectively earned 8.9% interest that year.
factor, lease rate, or factor). The money factor is usually given as a decimal, for example . To find the equivalent APR, the money factor is multiplied by 2400. A money factor of .0030 is equivalent to a monthly interest rate of 0.6% and an APR of 7.2%.
For a leasing arrangement with an initial capital cost of C, a residual value at the end of the lease of F and a monthly interest rate of r, monthly interest starts at Cr and decreases almost linearly during the term of the lease to a final value of Fr. The total amount of interest paid over the lease term of N months is therefore
and the average interest amount per month is
This amount is called the "monthly finance fee". The factor r/2 is called the "money factor"
The general conversion factor for APR to EAR is
,
where n represents the number of compounding periods of the APR per EAR period.
As an example, for a common credit card quoted at 12.99% APR compounded monthly, the one year EAR is
,
or 13.7975%.
For 12.99% APR compounded daily, the EAR paid on a stable balance over one year becomes 13.87% (see credit card interest
for the .000049 addition to the 12.99% APR). Note that a high U.S. APR of 29.99% compounded monthly 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 differences 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 $1755.87. 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 $23,070.86, which is over 11% of the original loan amount.
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, U.S. 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.
Consumers can, of course, use the nominal interest rate
and any costs on the loan (or savings account) and compute the APR themselves, for instance using one of the calculators on the internet.
In the example of a mortgage loan
, the following kinds of fees are:
The discretion that is illustrated in the "sometimes included" column even in the highly regulated U.S. home mortgage environment makes it difficult to simply compare the APRs of two lenders. Note: U.S. 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.
With respect to items that may be sold with vendor financing, for example, automobile leasing, the notional cost of the good may effectively be hidden and the APR subsequently rendered meaningless. An example is a case where an automobile is leased to a customer based on a "manufacturer's suggested retail price" with a low APR: the vendor may be accepting a lower lease rate as a trade-off against a higher sale price. Had the customer self-financed, a discounted sales price may have been accepted by the vendor; in other words, the customer has received cheap financing in exchange for paying a higher purchase price, and the quoted APR understates the true cost of the financing. In this case, the only meaningful way to establish the "true" APR would involve arranging financing through other sources, determining the lowest-acceptable cash price and comparing the financing terms (which may not be feasible in all circumstances). For leases where the lessee has a purchase option at the end of the lease term, the cost of the APR is further complicated by this option. In effect, the lease includes a put option
back to the manufacturer (or, alternatively, a call option for the consumer), and the value (or cost) of this option to the consumer is not transparent.
Furthermore, most APR calculators assume that an individual will keep a particular loan until it is completely paid off resulting in the up-front fixed closing costs being amortized over the full term of the loan. If the consumer pays the loan off early, the effective interest rate achieved will be significantly higher than the APR initially calculated. This is especially problematic for mortgage loans where typical loan durations are 15
or 30 years but where many borrowers move or refinance before the loan period runs out.
In theory, this factor should not affect any individual consumer's ability to compare the APR of the same product (same duration loan) across vendors. APR may not, however, be particularly helpful when attempting to compare different products.
Three 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.
(also known as Regulation Z). In general, APR in the United States is expressed as the periodic interest rate times the number of compounding periods in a year (also known as the nominal interest rate
); since the APR must include certain non-interest charges and fees, however, it requires more detailed calculation. The APR must be disclosed to the borrower within 3 days of applying for a mortgage. This information is typically mailed to the borrower and the APR is found on the truth in lending disclosure statement, which also includes an amortization schedule.
On July 30, 2009, provisions of the Mortgage Disclosure Improvement Act of 2008 (MDIA) came into effect. A specific clause of this act refers directly to APR disclosure on mortgages. It states, if the final annual percentage rate APR is off by more than .125% from the initial GFE
disclosure then the lender must re-disclose and wait yet another three business days before closing on the transaction.
The calculation for "close-ended credit" (such as a home mortgage or auto loan) can be found here. The calculation for "open-ended credit" (such as a credit card, home equity loan or other line of credit) can be found here.
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. The basic equation for calculation of APR in the EU is:
In this equation the left side is the present value
of the draw downs made by the lender and the right side is the present value
of the repayments made by the borrower. In both cases the present value
is defined given the APR as the interest rate. So the present value
of the drawdowns is equal to the present value
of the repayments, given the APR as the interest rate.
Note that neither the amounts nor the periods between transactions are necessarily equal. For the purposes of this calculation, a year is presumed to have 365 days (366 days for leap years), 52 weeks or 12 equal months. An equal month is presumed to have 30 5/12 days regardless of whether or not it is a leap year. The result is to be expressed to at least one decimal place. This algorithm for APR is required for some but not all forms of consumer debt in the EU. For example, this EU directive is limited to agreements of €50,000 and below and excludes all mortgages.http://ec.europa.eu/consumers/cons_int/fina_serv/cons_directive/2ndproposal_en.pdf
In the Netherlands the formula above is also used for mortgages. In many cases the mortgage is not always paid back completely at the end of period
, but for instance when the borrower sells his house or dies. In addition, there is usually only one payment of the lender to the borrower: in the beginning of the loan. In that case the formula becomes:
If the length of the periods are equal (monthly payments) then the summations can be simplified using the formula for a geometric series. Either way, the APR can be solved iteratively only from the formulas above, apart from trivial cases such as
.
, to ensure comparability of loans – and is required to be published for all regulated loans. The APR must be displayed at least as prominently as any other rate or charge.
The method used to calculate APRs in the EU and UK is different from that used in the U.S. and will often produce different (higher) results. This is because the U.S. method (regulation "Z" found on the federal truth in lending statement) produces what would, in the UK, be called a nominal annual rate
whereas the UK/EU method results in an effective annual rate.
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
, mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
, etc. It is a finance charge expressed as an annual rate. Those terms have formal, legal definitions in some countries or legal jurisdiction
Jurisdiction
Jurisdiction is the practical authority granted to a formally constituted legal body or to a political leader to deal with and make pronouncements on legal matters and, by implication, to administer justice within a defined area of responsibility...
s, but in general:
- The nominal APR is the simple-interest rate (for a year).
- The effective APR is the fee+compound interestCompound interestCompound interest arises when interest is added to the principal, so that from that moment on, the interest that has been added also itself earns interest. This addition of interest to the principal is called compounding...
rate (calculated across a year).
The nominal APR is calculated as: the rate, for a payment period, multiplied by the number of payment periods in a year. However, the exact legal definition of "effective APR", or EAR in short, can vary greatly in each jurisdiction, depending on the type of fees included, such as participation fees, loan origination
Loan origination
Loan origination is the process by which a borrower applies for a new loan, and a lender processes that application. Origination generally includes all the steps from taking a loan application through disbursal of funds . Loan servicing generally covers everything after disbursing the funds until...
fees, monthly service charges, or late fee
Late fee
A late fee, also known as a late fine or a past due fee, is a charge levied against a client by a company or organization for not paying a bill or returning a rented or borrowed item by its due date. Its use is most commonly associated with businesses like creditors, video rental outlets and...
s. The effective APR has been called the "mathematically-true" interest rate for each year.
The computation for the effective APR, as the fee+compound interest
Compound interest
Compound interest arises when interest is added to the principal, so that from that moment on, the interest that has been added also itself earns interest. This addition of interest to the principal is called compounding...
rate, can also vary depending on whether the up-front fees, such as origination or participation fees, are added to the entire amount, or treated as a short-term loan due in the first payment. When start-up fees are paid as first payment(s), the balance due might accrue more interest, as being delayed by the extra payment period(s).
In some areas, the annual percentage rate (APR) is the simplified counterpart to the effective interest rate
Effective interest rate
The effective interest rate, effective annual interest rate, annual equivalent rate or simply effective rate is the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest payable in arrears.It is used to compare the...
that the borrower will pay on a loan. When not using the term "effective APR", the use of "APR" is an early term for nominal APR. In many countries and jurisdictions, lenders (such as banks) are required to disclose the "cost" of borrowing in some standardized way as a form of consumer protection
Consumer protection
Consumer protection laws designed to ensure fair trade competition and the free flow of truthful information in the marketplace. The laws are designed to prevent businesses that engage in fraud or specified unfair practices from gaining an advantage over competitors and may provide additional...
. 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, due to the addition of other fees that may need to be included in the APR. APRs can be found by asking the lender or by reading the appropriate section in the contract.
In the U.S.
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
and the UK
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
, lenders are required to disclose the APR before the loan (or credit application) is finalized (although the definition of "APR" is not the same in the two countries-–see below). Credit card companies can advertise monthly interest rates, but they are required to clearly state the annual percentage rate before an agreement is signed. APR is a term used with regard to deposit accounts as well. However, when dealing with deposit accounts, the annual percentage yield
Annual Percentage Yield
Annual percentage yield is a normalized representation of an interest rate, based on a compounding period of one year. APY figures allow for a reasonable, single-point comparison of different offerings with varying compounding schedules...
(APY) or annual equivalent rate (AER) is quoted to consumers for comparison purposes.
Multiple definitions of effective APR
There are at least three ways of computing effective annual percentage rate:- by compounding the interest rate for each year, without considering fees;
- origination fees are added to the balance due, and the total amount is treated as the basis for computing compound interest;
- the origination feeOrigination feeAn origination fee, or activation fee, is a payment associated with the establishment of an account with a bank, broker or other company providing services handling the processing associated with taking out a loan....
s are amortizedAmortizationAmortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used...
as a short-term loan. This loan is due in the first payment(s), and the unpaid balance is amortized as a second long-term loan. The extra first payment(s) is dedicated to primarily paying origination fees and interest charges on that portion.
For example, consider a $100 loan which must be repaid after one month, plus 5%, plus a $10 fee. If the fee is neglected, this loan has a (year-long) effective APR of approximately 79% (
). If the $10 fee were considered, the monthly interest increases by 10% ($10/$100), and the effective APR becomes approximately 435% (, as 535%-100%=435%). Hence there are at least two possible "effective APRs": 79% and 435%. Laws vary as to whether fees must be included in APR calculations.Additional considerations
Confusion is possible in that if the word "effective" is used separately as meaning "influential" or having a "long-range effect", then the term effective APR will vary, as it is not a strict legal definition.the APR is used to find compound and simple interest rates.
Rate format
An effective annual interest rate of 10% can also be expressed in several ways:- 0.7974% effective monthly interest rate, because 1.007974^12=1.1
- 9.569% annual interest rate compounded monthly, because 12*0.7974=9.569
- 9.091% annual rate in advance, because (1.1-1)/1.1=0.091
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".
The APR does not necessarily convey the total amount of interest paid over the course of a year: if one pays part of the interest prior to the end of the year, the total amount of interest paid is less.
In the case of a loan with no fees, the amortization schedule
Amortization schedule
An amortization schedule is a table detailing each periodic payment on an amortizing loan , as generated by an amortization calculator. Amortization refers to the process of paying off a debt over time through regular payments...
would be worked out by taking the principal left at the end of each month, multiplying by the monthly rate and then subtracting the monthly payment. This can be expressed mathematically by
- where:
-
is the initial principal -
is the percentage rate used each payment -
is the number of payments
-
This also explains why a 15 year mortgage and a 30 year mortgage with the same APR would have different monthly payments and a different total amount of interest paid. There are many more periods over which to spread the principal, which makes the payment smaller, but there are just as many periods over which to charge interest at the same rate, which makes the total amount of interest paid much greater. For example, $100,000 mortgaged (without fees, since they add into the calculation in a different way) over 15 years costs a total of $193,429.80 (interest is 93.430% of principal), but over 30 years, costs a total of $315,925.20 (interest is 215.925% of principal).
In addition the APR takes costs into account. Suppose for instance that $100,000 is borrowed with $1000 one-time fees paid in advance. If, in the second case, equal monthly payments are made of $946.01 against 9.569% compounded monthly then it takes 240 months to pay the loan back. If the $1000 one-time fees are taken into account then the yearly interest rate paid is effectively equal to 10.31%.
The APR concept can also be applied to savings accounts: imagine a savings account with 1% costs at each withdrawal and again 9.569% interest compounded monthly. Suppose that the complete amount including the interest is withdrawn after exactly one year. Then, taking this 1% fee into account, the savings effectively earned 8.9% interest that year.
Money factor
The APR can also be represented by a money factor (also known as the leaseLease
A lease is a contractual arrangement calling for the lessee to pay the lessor for use of an asset. A rental agreement is a lease in which the asset is tangible property...
factor, lease rate, or factor). The money factor is usually given as a decimal, for example . To find the equivalent APR, the money factor is multiplied by 2400. A money factor of .0030 is equivalent to a monthly interest rate of 0.6% and an APR of 7.2%.
For a leasing arrangement with an initial capital cost of C, a residual value at the end of the lease of F and a monthly interest rate of r, monthly interest starts at Cr and decreases almost linearly during the term of the lease to a final value of Fr. The total amount of interest paid over the lease term of N months is therefore
and the average interest amount per month is
This amount is called the "monthly finance fee". The factor r/2 is called the "money factor"
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.Nominal APR does not reflect the true cost
Credit card holders should be aware that most U.S. 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
,where n represents the number of compounding periods of the APR per EAR period.
As an example, for a common credit card quoted at 12.99% APR compounded monthly, the one year EAR is
,or 13.7975%.
For 12.99% APR compounded daily, the EAR paid on a stable balance over one year becomes 13.87% (see credit card interest
Credit card interest
Credit card interest is the principal way in which credit card issuers generate revenue. A card issuer is a bank or credit union that gives a consumer a card or account number that can be used with various payees to make payments and borrow money from the bank simultaneously...
for the .000049 addition to the 12.99% APR). Note that a high U.S. APR of 29.99% compounded monthly 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 differences 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 $1755.87. 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 $23,070.86, which is over 11% of the original loan amount.
Certain fees are not considered
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:- 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, 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, U.S. 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.
Not a comparable standard
Even beyond the non-included cost components listed above, regulators have been unable to completely define which one-time fees must be included and which excluded from the calculation. This leaves the lender with some discretion to determine which fees will be included (or not) in the calculation.Consumers can, of course, use the nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
and any costs on the loan (or savings account) and compute the APR themselves, for instance using one of the calculators on the internet.
In the example of a mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, the following kinds of fees are:
Generally included:
|
Sometimes included:
|
Generally not included:
|
The discretion that is illustrated in the "sometimes included" column even in the highly regulated U.S. home mortgage environment makes it difficult to simply compare the APRs of two lenders. Note: U.S. 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.
With respect to items that may be sold with vendor financing, for example, automobile leasing, the notional cost of the good may effectively be hidden and the APR subsequently rendered meaningless. An example is a case where an automobile is leased to a customer based on a "manufacturer's suggested retail price" with a low APR: the vendor may be accepting a lower lease rate as a trade-off against a higher sale price. Had the customer self-financed, a discounted sales price may have been accepted by the vendor; in other words, the customer has received cheap financing in exchange for paying a higher purchase price, and the quoted APR understates the true cost of the financing. In this case, the only meaningful way to establish the "true" APR would involve arranging financing through other sources, determining the lowest-acceptable cash price and comparing the financing terms (which may not be feasible in all circumstances). For leases where the lessee has a purchase option at the end of the lease term, the cost of the APR is further complicated by this option. In effect, the lease includes a put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
back to the manufacturer (or, alternatively, a call option for the consumer), and the value (or cost) of this option to the consumer is not transparent.
Dependence on loan period
APR is dependent on the time period for which the loan is calculated. That is, the APR for one loan with a 30 year loan duration 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.Furthermore, most APR calculators assume that an individual will keep a particular loan until it is completely paid off resulting in the up-front fixed closing costs being amortized over the full term of the loan. If the consumer pays the loan off early, the effective interest rate achieved will be significantly higher than the APR initially calculated. This is especially problematic for mortgage loans where typical loan durations are 15
or 30 years but where many borrowers move or refinance before the loan period runs out.
In theory, this factor should not affect any individual consumer's ability to compare the APR of the same product (same duration loan) across vendors. APR may not, however, be particularly helpful when attempting to compare different products.
Interest-only loans
Since the principal loan balance is not paid down during the interest-only term, the total interest paid over the lifetime of the loan is increased and the APR is higher than a loan without an interest-only payment period.Three 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.
United States
In the U.S., the calculation and disclosure of APR is governed by the Truth in Lending ActTruth in Lending Act
The Truth in Lending Act of 1968 is United States federal law designed to promote the informed use of consumer credit, by requiring disclosures about its terms and cost to standardize the manner in which costs associated with borrowing are calculated and disclosed...
(also known as Regulation Z). In general, APR in the United States is expressed as the periodic interest rate times the number of compounding periods in a year (also known as the nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
); since the APR must include certain non-interest charges and fees, however, it requires more detailed calculation. The APR must be disclosed to the borrower within 3 days of applying for a mortgage. This information is typically mailed to the borrower and the APR is found on the truth in lending disclosure statement, which also includes an amortization schedule.
On July 30, 2009, provisions of the Mortgage Disclosure Improvement Act of 2008 (MDIA) came into effect. A specific clause of this act refers directly to APR disclosure on mortgages. It states, if the final annual percentage rate APR is off by more than .125% from the initial GFE
Good faith estimate
A good faith estimate, referred to as a GFE, must be provided by a mortgage lender or broker in the United States to a customer, as required by the Real Estate Settlement Procedures Act...
disclosure then the lender must re-disclose and wait yet another three business days before closing on the transaction.
The calculation for "close-ended credit" (such as a home mortgage or auto loan) can be found here. The calculation for "open-ended credit" (such as a credit card, home equity loan or other line of credit) can be found here.
European Union
In the EU, the focus of APR standardization is heavily on the standardization of the time-value of the interest calculation. As of Oct 2005, the EU still allows Member States to determine the specific cost-components to be included in the APR calculation.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. The basic equation for calculation of APR in the EU is:
-
-
- where:
-
is the number of cash flows paid by the lender -
is the sequence number for the cash flows paid by the lender (draw down) -
is the cash flow (drawdown) in period 
-
is the total number of cash flows paid by the borrower -
is the sequence number of the cash flows paid by the borrower (repayment) -
is the cash flow (repayment) of period 
, and -
and 
is the interval, expressed in years and fractions of a year between the date of the first cash flow and the date of cash flow 
or 
. (
= 0.)
-
In this equation the left side is the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of the draw downs made by the lender and the right side is the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of the repayments made by the borrower. In both cases the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
is defined given the APR as the interest rate. So the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of the drawdowns is equal to the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of the repayments, given the APR as the interest rate.
Note that neither the amounts nor the periods between transactions are necessarily equal. For the purposes of this calculation, a year is presumed to have 365 days (366 days for leap years), 52 weeks or 12 equal months. An equal month is presumed to have 30 5/12 days regardless of whether or not it is a leap year. The result is to be expressed to at least one decimal place. This algorithm for APR is required for some but not all forms of consumer debt in the EU. For example, this EU directive is limited to agreements of €50,000 and below and excludes all mortgages.http://ec.europa.eu/consumers/cons_int/fina_serv/cons_directive/2ndproposal_en.pdf
In the Netherlands the formula above is also used for mortgages. In many cases the mortgage is not always paid back completely at the end of period
, but for instance when the borrower sells his house or dies. In addition, there is usually only one payment of the lender to the borrower: in the beginning of the loan. In that case the formula becomes:
-
-
- where:
-
is the borrowed amount -
is the prepaid onetime fee -
the rest debt, the amount that remains as an interest-only loan after the last cash flow.
-
If the length of the periods are equal (monthly payments) then the summations can be simplified using the formula for a geometric series. Either way, the APR can be solved iteratively only from the formulas above, apart from trivial cases such as
.UK
APR was introduced under the Consumer Credit Act 1974Consumer Credit Act 1974
The Consumer Credit Act 1974 is an Act of the Parliament of the United Kingdom that significantly reformed the law relating to consumer credit within the United Kingdom....
, to ensure comparability of loans – and is required to be published for all regulated loans. The APR must be displayed at least as prominently as any other rate or charge.
- The leaflet Credit charges and APR from the Office of Fair TradingOffice of Fair TradingThe Office of Fair Trading is a not-for-profit and non-ministerial government department of the United Kingdom, established by the Fair Trading Act 1973, which enforces both consumer protection and competition law, acting as the UK's economic regulator...
The method used to calculate APRs in the EU and UK is different from that used in the U.S. and will often produce different (higher) results. This is because the U.S. method (regulation "Z" found on the federal truth in lending statement) produces what would, in the UK, be called a nominal annual rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
whereas the UK/EU method results in an effective annual rate.
External links
- http://www.fdic.gov/regulations/compliance/handbook/manual%20197-202.pdf FDIC Finance Charge and APR calculation rules
- http://www.investopedia.com/terms/a/apr.asp
- http://www.margill.com/white-paper-interest.htm White Paper: More than Math, The Lost Art of Interest calculation
- http://www.bbc.co.uk/raw/money/express_unit_percentages/ Introduction to percentages and understanding APR with BBC raw money
- Mortgage APR Calculator
- Mortgage Calculator with APR Function
- http://www.federalreserve.gov/reportforms/formsreview/RegZ_20090519_ffr.pdf Mortgage Disclosure Improvement Act or MDIA