APR is a numerical figure used to express the cost of credit. Lenders are required to fully disclose the APR to consumers by law. APR allows consumers to compare loans and determine the least expensive credit products, but can be confusing as lenders have flexibility in calculating APR and several fees are included in one APR.
An annual percentage rate or APR is a numerical figure used to express the cost of credit. It is the annual amount that a consumer must pay to acquire a loan or other type of credit. By law, lenders are required to fully disclose the APR to consumers.
The law that requires disclosure of the cost of the loan is called the Truth in Lending Act. Originally enacted in 1968, the Truth in Lending Act was instituted as part of the Consumer Protection Act. In 1980, it was reformed and simplified as part of the Deregulation and Monetary Control of Depository Institutions Law.
The intended function of the APR is to allow consumers to compare loans and determine which loans or other types of credit are the least expensive. The APR serves to make it harder for lenders to hide fees while advertising low interest rates. Essentially, APRs level out the highly competitive lending market and help consumers make informed lending decisions.
While APRs can be used to compare loans and determine the least expensive credit products, they can also be confusing. Each lender may calculate APRs in a different way. Therefore, a loan with a lower APR may not necessarily be less expensive than one with a higher APR.
Lenders have some flexibility when it comes to calculating APR. Without violating the law, they can understate a loan’s APR by as much as 1/8 percentage point. For loans that are considered non-performing, lenders may understate APRs by up to 1/4 percentage point.
To make things even more confusing, several fees are included in one APR. These rates vary, depending on the loan or credit product obtained. Points; prepaid interest; private mortgage insurance; and loan processing, document preparation, and underwriting fees are commonly included in an APR. Sometimes loan application fees and credit life insurance costs are included as well.
To avoid APR discrepancies when comparing credit costs, some lending experts suggest calculating APR on your own. This can be accomplished by obtaining good faith loan cost estimates from lenders who offer the same loan programs or credit products at the same interest rates. After compiling this information, subtract any fee amounts that are separate from the loan and add these fees separately. The loan with the lowest total fee is the cheapest loan. However, this method only works when comparing loans that have the same interest rates.
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