Annual Percentage Rate
01. The Annual Percentage Rate and Finance Charges
Credit costs vary. By remembering two terms, you can compare credit prices from different sources. Under the Truth in Lending Law, the creditor must tell you, in writing and before you sign any agreement, the finance charge and the annual percentage rate.
The finance charge is the total dollar amount you pay to use credit. It includes interest costs, and other costs, such as service charges and some credit-related insurance premiums.
For example, borrowing $100 for a year might cost you $10 in interest. If there were also a service charge of $1, the finance charge would be $11.
The annual percentage rate (APR) is the percentage cost (or relative cost) of credit on a yearly basis. This is your key to comparing costs, regardless of the amount of credit or how long you have to repay it.
Again, suppose you borrow $100 for one year and pay a finance charge of $10. If you can keep the entire $100 for the whole year and then pay back $110 at the end of the year, you are paying an APR of 10 percent. But, if you repay the $100 and finance charge (a total of $110) in twelve equal monthly installments, you don't really get to use $100 for the whole year. In fact, you get to use less and less of that $100 each month. In this case, the $10 charge for credit amounts to an APR of 18 percent.
All creditors, including banks, stores, car dealers, credit card companies and finance companies, must state the cost of their credit in terms of the finance charge and the APR. Federal law does not set interest rates or other credit charges. But it does require their disclosure so that you can compare credit costs. The law says these two pieces of information must be shown to you before you sign a credit contract or before you use a credit card.
02. Caution
The annual percentage rate (APR) was designed by the federal Truth in Lending Law to reveal the true total cost of getting a loan. For a home mortgage, the APR includes the interest rate and other added costs such as loan-origination fees and points.
Unfortunately, the APR may leave out fees for underwriting, document preparation, processing, tax services, credit reports and property appraisals. These fees can easily add another $2,000 to the cost of getting a loan. Even though you have to pay these fees, they may not be included in the APR.
Though some lenders do include all costs in their APR calculations, many don't, making it difficult to compare one lender with another. Another problem is that some lenders don't reveal the APR until after you've paid a nonrefundable application fee.
Be careful not to confuse the APR with the note rate or nominal rate. The note rate is the one used to actually calculate your monthly payments and is the rate you usually see advertised. The APR, however, is almost always higher than the note rate. Adding to all this confusion is that the note rate usually does not appear on required disclosure documents.
To be on the safe side, be sure to get an itemized list of all costs from each lender and compare them carefully. Be sure you know the difference between the note rate and the APR, and even ask the lender to show you how their annual percentage rate is calculated.