debt

How is a loan's interest rate calculated?

Don TaylorQuestionDear Dr. Don,
What items are included in an APR? Does it include the interest rate on the loan?
-- Bob Bewildered

AnswerDear Bob,
Lenders face specific requirements in how they calculate the annual percentage rate, or APR, on a loan. Those requirements are spelled out in the Truth in Lending Act, or TILA.

TILA is also known as Regulation Z of the Federal Reserve Board.

As described on the Fed's website, Regulation Z "prescribes uniform methods for computing the cost of credit, for disclosing credit terms, and for resolving errors on certain types of credit accounts." The intent of requiring lenders to provide the APR of a mortgage loan is to allow consumers to compare rates across lenders.

The APR definitely includes the interest rate on the loan. It also includes the disclosed finance charge on the loan. Because the disclosed finance charge can vary from the actual finance charge on the mortgage, APR isn't a perfect, apples-to-apples comparison across lenders. Regulation Z spells out the permissible tolerances in calculating the APR in Title 12, Part 226.

Short of calculating the APRs on your own, using the lender-provided APR estimate is a reasonable approach to comparison shopping across lenders.

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