The annual percentage rate (APR) is the effective rate of interest that is charged on an installment loan, such as those provided by banks, retail stores, and other lenders. Since the enactment of the Truth in Lending Act in 1969, lenders have been required to report the APR in boldface type on the first page of all loan contracts. The truth in lending law "requires lenders to disclose in great detail the terms and conditions that apply to consumers when they borrow," according to an article in United States Banker. "Its purpose was to allow consumers to shop for credit by comparing the fine print." In the absence of such requirements, it would conceivably be possible for a lender to misrepresent a loan with a 20 percent effective interest rate as a 10 percent loan. However, the APR can be calculated in different ways and can sometimes cause rather than eliminate confusion.
A loan is the purchase of the present use of money with the promise to repay the amount in the future according to a pre-arranged schedule and at a specified rate of interest. Loan contracts formally spell out the terms and obligations between the lender and borrower. Loans are by far the most common type of debt financing used by small businesses. The interest rate charged on the borrowed funds reflects the level of risk that the lender undertakes by providing the money. For example, a lender might charge a startup company a higher interest rate than it would a company that had shown a profit for several years. The interest rate also tends to be higher on smaller loans, since lenders must be able to cover the fixed costs involved in making the loans.
The lowest interest rate charged by lenders—which is offered only to firms that qualify on the basis of their size and financial strength—is known as the prime rate. All other types of loans feature interest rates that are scaled upward from the prime rate. Interest rates vary greatly over time, depending on the policies set forth by the Federal Reserve Board as well as prevailing economic conditions in the nation. For all but the simplest of loans, the nominal or stated rate of interest may differ from the annual percentage rate or effective rate of interest. These differences occur because loans take many forms and cover various time periods. The effect of compounding and the addition of fees may also affect the APR of a loan.
The effective rate of interest on a loan can be defined as the total interest paid divided by the amount of money received. For simple interest loans—in which the borrower receives the face value of the loan and repays the principal plus interest at maturity—the effective rate and the nominal rate are usually the same. As an example, say that a small business owner borrows $10,000 at 12 percent for 1 year. The effective rate would thus be $1,200 /$10,000 12 percent, the same as the stated rate.
But the effective rate would be slightly different for a discount interest loan, wherein the interest is deducted in advance so the borrower actually receives less than the face value. Using the same example, the small business owner would pay the $1,200 interest up front and receive $8,800 upon signing the loan contract. In this case, the effective interest rate would be $1,200 /$8,800 13.64 percent.
The most problematic differences between the nominal and effective rates of interest occur with installment loans. In this type of loan, the interest is calculated based on the nominal rate and added back in to get the face value of the loan. The loan amount is then repaid in equal installments during the loan period. Using the same example, the small business owner would sign for a loan with a face value of $11,200 and would receive $10,000. Since the loan is repaid in monthly installments, however, the business owner would not actually have use of the full loan amount over the course of the year. Instead, assuming 12 equal installments, the business owner would actually have average usable funds from the loan of $5,000. The effective rate of the loan is thus $1,200 /$5,000 24 percent, twice the stated rate of the loan.
True APR calculations should also include any up-front fees or penalties that are applied to a loan. These amounts are totaled and added to the interest figure. In the case of mortgage loans, such charges can be significant. They might include a mortgage insurance premium, points, lost interest earnings on escrow accounts, and prepayment penalties, for example.
Brigham, Eugene F. Fundamentals of Financial Management. Dryden Press, 1989.
Eaglesham, Jean. "APRs Daze and Confuse." Financial Times. April 16, 1997.
Heath, Gibson. Doing Business with Banks: A Common Sense Guide for Small Business Borrowers. Lakewood, CO: DBA/USA Press, 1991.
Lee, Jinkook, and Jeanne M. Hogarth. "The Price of Money: Consumers' Understanding of APRs and Contract Interest Rates." Journal of Public Policy and Marketing. Spring 1999.
"Preparing for Truth in Savings." United States Banker. November 1992.