Annual percentage rate (APR)

Before you rely on it

What to check

Read which charges the lender folded in. Inclusion rules cover some fees and not others.

The common error

Where people go wrong with annual percentage rate (APR)

Comparing one lender's APR to another's without comparing their fee lists. Two APRs built from different charge sets are not a like-for-like comparison, and the gap can be hundreds of dollars a year.

Worked through

Annual percentage rate (APR) in plain numbers

A lender offers $10,000 over five years at 6%, with a $200 origination fee taken out of the proceeds; the monthly payment on $10,000 at 6% is $193.33. But you only receive $9,800. Ask what rate makes 60 payments of $193.33 worth exactly $9,800 today, and the answer is about 0.57% a month. Multiply by twelve and the APR is roughly 6.84%, and the interest rate on the paperwork says 6%. The cost of the money says nearly 7%. A second lender at 6.5% with no fee has an APR of 6.5%, and it is the cheaper loan, though its headline rate looks higher.

Easily confused

Annual percentage rate (APR) and its neighbours

APR is not the interest rate, and it is not the effective annual rate either; the interest rate prices the balance and nothing else. APR adds certain fees and stretches the total over the term to give one annual figure; the effective annual rate, or APY on a deposit, adds the effect of compounding within the year, and APR generally does not. Two loans can carry the same APR and cost different amounts if one has a prepayment penalty or a balloon. Use APR to compare offers with similar structures. Do not use it to compare a fixed loan with an adjustable one, because the adjustable APR assumes today's rate holds.

In real decisions

Where annual percentage rate (APR) turns up

APR is the number a lender must show you before you sign, which is what makes it useful; it appears on mortgage estimates, car loans, credit cards and personal loans. Shopping three lenders on the same day, you line up the APRs first and then read the fee lists behind them. It also sets your expectations for a card balance, where the APR drives the interest charged each month. If you plan to keep a loan for its full term, APR is close to the truth. If you plan to pay it off in a year, the fees weigh more heavily and APR understates the real cost.

Know the edges

Where annual percentage rate (APR) stops being reliable

APR only includes charges the rules say must be included, so two lenders can bundle different fees into the figure; some costs, such as certain closing charges, sit outside it. On adjustable and variable products it reflects only the starting rate. And it assumes you hold the loan to term. Pay off early and the fees are spread over fewer months, so the true annual cost rises. Always ask for the full fee list and a payoff example, and do the arithmetic yourself before treating APR as final.