Annual Percentage Rate (APR) is an expression of the effective interest rate that will be paid on a loan. It is different from the "note rate" (the advertised interest rate) because it includes one-time fees in an attempt to calculate a "total cost" of borrowing money.
In a simplified example, if you borrow $100 for one year at 5% simple interest (meaning that you will owe $105 at the end of the year) and you pay the lender a $5 origination fee, your total cost to borrow the money will be $10 ($5 for the simple interest plus $5 for the origination fee) and your APR is a bit less than 10%.
APR is intended to make it easier to compare lenders. In the US, lenders are required to disclose the APR before the loan (or credit application) is finalized.
While there are several acceptable ways to calculate the exact APR, the general process is:
- Total the included one-time costs and add them to the face amount on the loan
- Calculate a monthly payment for that amount at the loan's "note rate"
- Calculate what interest rate would have to be applied to just the face amount of the loan in order to equal the calculated monthly payment in step
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