||Ask Dr. Don
APR vs. interest rate
Dear Dr. Don,
It would seem like the terms "APR" and "Interest
Rate" would be fully understood by now. However, as much as
I seek out what the differences are, I only end up with more questions.
Why is it that APR is considered an apples-to-apples
comparison between lenders when the interest rate is what you'll
be making monthly payments on? Why is it that interest rates are
sometimes much higher than the APR, if the APR should be what you
would be paying on the cost of the loan, including up-front closing
It is confusing.
The nominal rate of interest is the rate used when
calculating the interest expense on your loan. That's what most
people consider to be the interest rate on their loan. The annual
percentage rate (APR) on a loan includes some of the costs involved
in procuring the loan and is meant to provide the consumer with
an effective rate to use when comparing loans.
Act is implemented by the Federal Reserve Board's Regulation
Z and sets the standards for how APRs are calculated. Since
lenders have to abide by these standards, there is a basis for comparison
The APR on a fixed-rate loan should always be greater
than or equal to the nominal interest rate. For it to be lower would
require that the lender rebate back to you some of your interest
The disclosure of an APR is considered accurate if
the rate disclosed is within an eighth of a percent more or less
than the actual rate, or the actual rate rounded to the nearest
quarter of a percentage point. (The Federal Reserve Board may also
allow a greater tolerance to simplify compliance where irregular
payments are involved.)
The U.S. Code, Title 15, Chapter 41 (Consumer
Credit Protection) gives all the details about what is and isn't
included in calculating the finance charge on your loan. Beyond
the rounding permitted by law, the biggest problem in comparing
APRs from different lenders is the lender's ability to estimate
the closing costs that are included in the APR calculation.
Use the lenders' APRs to help you choose which loan.
If the rates are close, you should dig deeper. Either ask the lenders
to show you the costs they included in their APR calculations and
discuss with them whether these costs are actual or estimated, or
calculate your own APR for the competing loans.
Wheatworks gives you a free trial of their APR
Calculator that allows you to compile your own APRs for competing
-- Posted: Dec. 13, 2001