This is a very interesting question – especially in light of how important everybody from idiotic politicians to equally uninformed journalists seem to think it is. Personally I’ve never met ANYONE who actually knows what it is outside the lending industry, and surprisingly most people IN the lending industry don’t really understand it.
So what is it? Is it the “actual or real interest rate?” No. Is it effective for comparing two different loans with different fees? Not usually. Does it represent what the actual costs will be for most borrowers over the life of their loan? No. Is their a consensus on how it is to be calculated? No. Is it confusing? Yes. Do lenders get sued and have to pay large sums of money for doing it incorrectly? Yes. So just what DOES it do? Good question; maybe if you read this entire piece you will be able to answer it.
History: In 1968 the Truth in Lending Act (TILA) was signed into law and created the term Annual Percentage Rate (APR) among others. The law has been amended and changed many times since then, but the basics are still the same as it relates to APR. Its purpose was to help consumers to be able to compare loan options with different costs to determine what option was best for them.
For example: Loan A is for $100,000, is a 30-year loan has an interest rate of 6.00% with a payment of $599.55, and has costs of $3,000. Loan B is also a 30-year loan for $100,000 but it has an interest rate of 5.75%, a payment of $583.57, and costs of $4,500. The APR is supposed to help you decide between them.
How it works: TILA actually creates three terms. The first one is the Prepaid Finance Charge – This is the total closing costs necessary to get the loan. The second term is the Amount Financed – This is the loan amount less the Prepaid Finance Charge. The Annual Percentage Rate is then determined by calculating what the interest rate would be assuming the Amount Financed is the loan amount.
For you Excel formula geeks out there: RATE (360, payment*-1, loan amount – pre-paid finance charges) The RATE is the APR.
Why is this a problem? Well in the examples above, if we assume the closing costs indicated are all Prepaid Finance Charges, the APR on the 6.00% loan would be 6.286% and the APR on the 5.75% loan would be 6.178%. One would assume that the better of the two is the 5.75% since both the note rate & the APR are lower. However unless the borrower makes all 360 payments just as the loan was designed, those numbers don’t mean anything. What is probably more important is that the difference between the two payments is only $15.98 a month. So while the payment on the 5.75% loan will be lower, it will take over seven years before the borrower will have recouped the extra $1,500 they paid up-front with the $15.98 a month lower payment. If they sold the house or refinanced the loan before that seven year time the lower rate loan would have cost them money.
Well, can you answer the question? Let me help you. The APR is an excellent way of comparing two loans with different rates and different fee structures – so long as you intend to keep the loan for the entire term. Unfortunately if you pay the loan off early in the term, the APR is of little or no help.