Christopher A. HopkinsIf you’ve ever been puzzled by the difference between interest rate and APR, you’re in the right place. For an explanation of why “Love after Lockup” is still on TV, consult the Oracle of Delphi.
The annual percentage rate is the effective annual interest rate on a loan including most ancillary charges and origination costs in addition to simple loan interest. The 1968 Truth in Lending Act established an obligation on the part of lenders to disclose this defined rate to assist consumers in accurately comparing loan offers with differing terms.
The most obvious example is in mortgage lending. Mortgage interest rates for a 30-year loan to borrowers with good credit are still close to 4%. This is the “nominal” rate applied to the amount outstanding on the loan each month. But home loans carry additional costs, including origination and underwriting fees, legal expenses, broker fees and discount points. The APR wraps these fees into the loan and presents the true annualized cost. This allows buyers to accurately compare, say, a 4.2% mortgage with zero points against a 3.9% loan with 1.5 points. Lenders are also required to compute the total of all payments over the life of the mortgage.
The same principle applies to car loans. The nominal rate understates the total cost of credit; the APR takes all additional loan fees into account and provides a tool for apples-to-apples comparison.
Beginning in the 1980s, many auto companies discovered an end run around disclosure of the true APR. Low interest or “zero percent” loans became common, suggesting to buyers the availability of below-market financing rates. Of course in reality, the imputed finance charge is rolled into the purchase price of the vehicle. By holding the total of payments constant but increasing the car price, the disclosed interest rate appeared artificially low. A cash buyer would enjoy a lower price since there are no hidden finance charges.