- Annual percentage rate is a significant figure that helps consumers compare different loans and accounts. Credit card companies and money lenders are required by the federal Truth in Lending Act to declare the APR of loans when they advertise a rate. This reveals the true cost of different types of interest compounding, penalties and fees. This also applies to savings accounts. The APR reveals the true rate of interest an account will pay after all the expenses are factored in.
- Annual percentage rate adds in many types of fees and expenses. These include the underwriting fee, document preparation fee and loan processing fee. Financial institutions also factor in private mortgage insurance, loan points and prepaid interest. The costs of these fees and expenses are the reason APR is always higher than the interest rate.
- A common misconception is that annual percentage rate factors in all the fees and expenses of a loan. This is not true. In fact different financial institutions can calculate some aspects of APR differently. Some lenders do not include the loan application fee and credit life insurance. Most lenders do not include the escrow fee, notary fee, recording fee, title fee, transfer taxes, home inspections, lawyer bills, appraisals or a credit report. These differences can affect the APR. Inquire about which fees are included and excluded from APR calculation when comparing rates.
- Another factor that must be considered is the time frame of a loan. A 15-year mortgage and a 30-year mortgage will have different costs even if they have the same annual percentage rate. Since the fees are factored in over different periods of time, the 30-year mortgage is more expensive. Calculating APR on an adjustable loan is impossible since it is not known what the interest rate will adjust to. In this case an APR range is usually calculated as an estimate.
- It is important to distinguish the difference between annual percentage rate and monthly percentage rate. The law allows credit card companies to state their interest rates by the month in addition to APR. This can be confusing for consumers. A credit card account can have an APR of 24 percent and an MPR as 2 percent. If consumers don't know the difference, they can think they are paying much less interest than they actually are.
