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What is the difference between the interest rate and the Annual Percentage Rate (APR)?

Perhaps the most frequently asked questions we have received, over the years, relate to the difference between the interest rate used to compute loan payments and the Regulation Z Annual Percentage Rate, or APR, in the Truth-In-Lending disclosure required on all consumer loans. Many people think that, in the absence of finance charges other than interest, such as service charges and prepaid finance charges, which will affect the APR, the interest rate and the APR should be the same. This article explains why that can be true, but is usually not the case.

The APR is designed to provide, as an annual rate, a measure of the true cost of a loan. It’s purpose is to enable consumers to do comparison shopping of overall finance charges, regardless of how individual lenders compute their loans. To calculate an APR, we need following data from a loan:

  1. The dates and amounts of all advances of amounts financed made by the lender to the borrower.

  2. The dates and amounts of all repayments made by the borrower to the lender.

From these “cash flows” back and forth, the APR can be computed. Note that the calculation of APR does not require knowledge of the method of computing interest that the lender used, nor any additional fees the lender might have imposed on the borrower as these are all reflected in the cash flows.