Meaning of Annual Percentage Rate (APR).

The term annual percentage rate (APR), also called nominal APR, and the term effective APR, also called EAPR, 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:-

1. The nominal APR is the simple-interest rate (for a year).

2. The effective APR is the fee+compound interest rate (calculated across a year).

The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.

Loans or credit agreements can vary in terms of interest-rate structure, transaction fees, late penalties and other factors. A standardized computation such as the APR provides borrowers with a bottom-line number they can easily compare to rates charged by other potential lenders.

By law, credit card companies and loan issuers must show customers the APR to facilitate a clear understanding of the actual rates applicable to their agreements. Credit card companies are allowed to advertise interest rates on a monthly basis (e.g. 2% per month), but are also required to clearly state the APR to customers before any agreement is signed. For example, a credit card company might charge 1% a month, but the APR is 1% x 12 months = 12%. This differs from annual percentage yield, which also takes compound interest into account.


Dependency of APR:-

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.


There are at least three ways of computing effective annual percentage rate:-

a) By compounding the interest rate for each year, without considering fees.

b) Origination fees are added to the balance due, and the total amount is treated as the basis for computing compound interest.

c) 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.


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 80%. If the $10 fee were considered, the monthly interest increases by 10% ($10/$100), and the effective APR becomes approximately 435%. Hence there are at least two possible "effective APRs": 80% and 435%. Laws vary as to whether fees must be included in APR calculations.
 
The term annual percentage rate (APR), also called nominal APR, and the term effective APR, also called EAPR, 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:-

1. The nominal APR is the simple-interest rate (for a year).

2. The effective APR is the fee+compound interest rate (calculated across a year).

The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.

Loans or credit agreements can vary in terms of interest-rate structure, transaction fees, late penalties and other factors. A standardized computation such as the APR provides borrowers with a bottom-line number they can easily compare to rates charged by other potential lenders.

By law, credit card companies and loan issuers must show customers the APR to facilitate a clear understanding of the actual rates applicable to their agreements. Credit card companies are allowed to advertise interest rates on a monthly basis (e.g. 2% per month), but are also required to clearly state the APR to customers before any agreement is signed. For example, a credit card company might charge 1% a month, but the APR is 1% x 12 months = 12%. This differs from annual percentage yield, which also takes compound interest into account.


Dependency of APR:-

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.


There are at least three ways of computing effective annual percentage rate:-

a) By compounding the interest rate for each year, without considering fees.

b) Origination fees are added to the balance due, and the total amount is treated as the basis for computing compound interest.

c) 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.


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 80%. If the $10 fee were considered, the monthly interest increases by 10% ($10/$100), and the effective APR becomes approximately 435%. Hence there are at least two possible "effective APRs": 80% and 435%. Laws vary as to whether fees must be included in APR calculations.

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