What's the APR and How is it Calculated?

What's the APR and How is it Calculated?
The term annual percentage rate (APR), also called nominal APR, and the term effective APR, also called EAR, describes 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 jurisdictions, but in general:

• The nominal APR is the simple-interest rate (for a year). 
• The effective APR is the fee+compound interest 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 fees, monthly service charges, or late fees. 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.

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 fees are amortized 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.

Source: http://en.wikipedia.org/

Annual Percentage Rate (APR)

What Is the APR?

APR is a measure of the cost of credit that includes loan fees paid to the lender upfront, as well as the interest rate. The higher are the loan fees, the larger will be the APR relative to the rate. If there are no loan fees and the rate is fixed through the life of the loan, the APR will equal the rate.

What Is the Purpose of the APR?

To provide a single comprehensive measure of the cost of credit to the borrower, which they can use to compare loans of different types and features, and loans offered by different loan providers.

The APR is a mandated disclosure under Truth in Lending. Mortgage shoppers confront it as soon as they search for interest rate quotes, because the law requires that any rate quote must also show the APR.

Can All Borrowers Rely Safely on the APR?

No, some should ignore the APR, including:

* Borrowers who expect that they will sell their house or refinance the mortgage     within 7 years.
* Borrowers looking to raise cash, who are comparing the cost of a cash-out refinancing with the cost of a second mortgage.
* Borrowers with little cash who need a high-rate loan with negative points (rebates) to cover their costs.
* Borrowers shopping for a home equity line of credit (HELOC).

The APR is most useful for borrowers shopping for an adjustable rate mortgage (ARM), who expect to hold the mortgage a long time, and who are not doing a cash-out refinance, a low or no-cost mortgage, or a HELOC.