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Annual Percentage Rate (APR)


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TERMINOLOGY


A helpful tool used to compare loans among different lenders is the Annual Percentage Rate (APR). The Federal Truth in Lending law requires mortgage companies to disclose the APR each time they advertise a rate. The APR is designed to standardize the representation of interest rates and convey the true cost of the loan to the borrower, expressed in the form of a yearly rate. The purpose is to prevent lenders from hiding fees and other upfront costs behind low advertised interest rates.

One confusing aspect of the APR is that calculation is dependent upon the length of the loan period, and therefore cannot be used to compare loans that have different durations (i.e. 30-year vs. 20-year). For this reason, APRs should only be used to compare similar products, and not loans that have different time-periods associated with their payments.

The APR does have many shortcomings, mostly tied to the fact that APR calculations are quite complex and vary among different lenders. This means that two lenders with identical information may still calculate two different APRs. Lenders have some discretion when choosing which fees will be included in the calculation of an APR, so different figures may be produced by different companies.

In addition, the APR model is flawed in that when a product is variable and tied to a market index, the index is assumed to never change for the purposes of calculation. This is an erroneous assumption that can produce APR figures that are not comparable between different lending sources.

The APR also won't tell you anything about balloon payments, pre-payment penalties, or how long your rate is locked in for. You can use APRs as a general guideline to shop for loans, but you should not depend solely on the APR to choose which loan is best for your needs.