An APR or annual percentage rate is a numerical figure used to express the cost of credit. It is the yearly amount a consumer must pay for acquiring a loan or other type of credit. By law, lenders are required to fully disclose the APR to consumers.
The law that requires loan-cost disclosure is called the Truth in Lending Act. Originally enacted in 1968, the Truth in Lending Act was instituted as part of the Consumer Protection Act. In 1980, it was reformed and simplified as part of the Depository Institutions Deregulations and Monetary Control Act.
The intended function of the APR is to allow consumers to compare loans and determine which loans or other types of credit are the least costly. The APR serves to make it more difficult for lenders to hide fees while advertising low interest rates. Essentially, APRs level the very competitive loan market and help consumers make informed borrowing decisions.
While APRs can be used to compare loans and determine the least expensive credit products, they can also be confusing. Each lender may calculate APRs in a different way. Therefore, a loan with a lower APR may not necessarily be less costly than one with a higher APR.
Lenders are afforded some flexibility when it comes to calculating APRs. Without breaking the law, they can underestimate the annual percentage rate of a loan by as much as 1/8 of a percentage point. For loans that are considered irregular, lenders may underestimate APRs by as much as 1/4 of a percentage point.
To make things even more confusing, various fees are included in an APR. These fees vary, depending on the loan or credit product obtained. Points; prepaid interest; private mortgage insurance; and fees for loan processing, document preparation, and underwriting are commonly included in an APR. Sometimes loan application fees and credit-life insurance costs are included as well.
To avoid APR discrepancies when comparing credit costs, some loan experts suggest calculating APRs on your own. This can be accomplished by obtaining good-faith loan cost estimates from lenders offering the same loan programs or credit products at the same interest rates. After compiling this information, subtract all fee amounts that are independent of the loan and add these fees separately. The loan that has the lowest total fee amount is the cheapest loan. However, this method only works when comparing loans that have the same interest rates.