In simplified terms, APR is an acronym for Annual Percentage Rate. The annual percentage rate is what a lender charges you for a full year of financing.

Example:

• you borrow $100,000 dollars for a full year
• the APR (annual percentage rate) is 7 %
• your total APR cost is $7000
• paid out monthly =  $583.33 in interest per month

Nominal APR

Nominal APR is known as the interest charged for a full year as described above.

Effective APR or EAR (effective annual rate)

Effective APR, know as EAR (acronym for Effective Annual Rate) is the sum of the nominal APR and the fees associated with the lending agreement’s terms and conditions. Using the example above let us say there is a mortgage fee of 1% costing you $1000 on the $100,000 loan. Our calculation for adding up our total Effective APR is as follows:

• nominal APR of $7000
• mortgage (loan) fee of $1000
• A total of $8000 charged

Your total Effective APR would be $8000 dollars on a loan of $100,000. Keeping in mind that is also a very simplified explanation of EAR (or effective APR)

Compound Interest and Jurisdictional Variances

The above definitions of the financial terms APR and EAR are very basic and I wish it was always that simple. Unfortunately APR can stand for different kinds of calculations such as the addition of compound interest.

Because of the past problems with predatory lenders abusing the definition of APR laws had to be made so that lenders must disclose true costs of the financing they give borrowers. This is why the Truth In Lending Act was made.

There is a formula for calculating the EAR on a loan and it goes as such:

EAR (Effective Annual Rate = [{1+APR/n}^n]-1

If you use the above equation you should get your true APR. In most all case the EAR will equal between .5 – 3 percentage points higher that the APR quoted. The difference in this range of extra interest is taking into account the different kinds of loan products in the market. A cash advance loan or a subprime loan will carry a higher EAR  due to the compound effect. For a mortgage or a conventional bank loan the EAR is usually .5 to 1 % higher than the so-called APR.

APR In Conclusion

Because of the variances in the so-called APR make sure you “nail down” your lender(s) on the true cost of the loan. Most States have laws on the books requiring all lenders to fully disclose the “true cost” of a loan, but the term APR fluctuations in definition between jurisdictions somewhat, so being vigilant when questioning bankers is recommended. Let the loan officer(s) know that you have a very good idea how finance works. Don’t be afraid to question banks on every line in their loan agreement(s).

With our without legislation, you need to be wary of non-conventional lenders, and find out what their TRUE EAR (Real Effective Annual Rate) is before even considering picking up their pen and signing the lending agreement.