Annual Percentage Rate (APR)

APR, or annual percentage rate, refers to the periodic cost of borrowing times the number of periods in a year and its use is somewhat regulated by the Truth in Lending act.  For example, if a credit card charges 1% interest per month, the annualized APR would be 1% X 12 months or 12%.  APR is intended to simplify the lending process by allowing borrowers to have one number that can be shopped around at different lenders.  It is intended for use in comparing loan products of similar terms and duration.  Comparing different loan terms will reduce the effectiveness of this number. 

Unfortunately, the APR is usually different than the advertised rate for a loan that you will typically find on TV or in other forms of advertisement.  That is because the lenders do not forcefully advertise the costs and fees associated to the loan and usually put the true cost in small print.  The APR is an attempt at including these fees.  Mortgages rate quotes are notorious for this form of trickery; often enticing borrowers with low rate promises, only to add in additional fees on the backend when the loan process begins. 

The effectiveness of this number has been questioned as many lenders choose to report APR using different methods, making it very difficult to make proper comparisons.  For example, a mortgage lender may include points, PMI (private mortgage insurance), origination fees, appraisal fees, title search fees, and credit report costs in their APR while another lender may choose to include all of these items with the exception of the title search.  An apples to apples comparison is very difficult without completely understanding what the APR consists of. 

Secondly,  APR does not get at the heart of the true cost of borrowing as it does not include compounded interest, as APY (Annual Percentage Yield) does.  For this reason, you will see many lenders advertise the APY for interest bearing accounts and the APR for mortgage type of loans.

APY vs. APR


APY is the annualized return, including compounded interest.  For example, suppose you put $1,000 into your bank account with an APR of 6%.  6% a year translates into .5%(6% / 12 months) periodic rate of return.  Now, let's convert the periodic rate of return to an annualized compounded rate of return, or APY.  .5% compounded over 12 periods translates into an annual percentage yield of 6.17%.  You can see how compounding differentiates the two figures.  When you are looking for a loan, or borrowing, banks will advertise APR to show you a lower rate.  Conversely, when you are looking to lend, or accumulate interest, banks will advertise the APY to entice you with a "higher" figure. 
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

Tradingsim.com
Day Trading Simulator

Tradingsim.com provides the ability to simulate day trading 24 hours a day from anywhere in the world. TradingSim provides tick by tick data for...

Send this article to a friend.

Enter multiple addresses on separate lines or separate them with commas.