The annual percentage rate (APR) is a financial measurement of the cost of credit. Under the Truth in Lending Act, lenders must report it to consumers before they sign up for any credit facilities.

Sometimes also known as nominal APR or effective APR, annual percentage rate is a finance charge expressed as an annualized interest rate.

The purpose of this simplified expression is to help consumers better understand the costs of the credit facilities and loans they are signing up for.

This is because the average consumer won’t truly understand how interest rate mechanisms work in a financial institution.

In a nutshell, the main goal of APR is to deter predatory lending.

The APR takes into account upfront charges, annual charges, and interest rate paid by the borrower. This means that it is usually higher than the interest rate of a facility as it also consist of upfront charges.

It also takes into account the time value of money. So inflation would mean that a dollar today would be worth less than that the following years.

This leaves a few crucial limitations to APR.

Incomplete fee coverage

In practice, APR would include only charges paid to lenders and mortgage brokers. No other third party fees are involved.

But in theory, it should also include all charges that will not suffice in a transaction made totally in cash.

This gave rise to the belief that APR tend to grossly understate the true costs of credit, resulting in incomplete fee coverage.

As the goal of APR is to disclose a clear picture to consumers of credit cost, inaccuracies in the APR’s make-up defeat the purpose of it altogether.

However, should the discrepancies be consistent, the figures could still give consumers a general idea of how much they are really paying for credit.

The problem is that it is anything but consistent.

For example, sometimes lenders leave out fees by waiving them in exchange for higher interest rates. The result of such actions can greatly impact the credibility of APR.

This is why borrowers shopping for a mortgage should avoid using APR as a comparison metrics as much as possible.

Otherwise they could be hooked onto one thinking that it is fairly cheap and affordable… when in fact it isn’t.

Assuming loans run the full course of their tenor

When we talk about personal loans for example, we tend to think that borrowers would continue making payments strictly adhering to the repayment schedule published by the lender.

This is assuming that at no point in time during the term will the borrower partially or fully redeem the loan.

The fact is that most borrowers only borrower to tide over a rough period. They sign up for a longer term for a lower installment payment and a safety buffer.

Once they get over that tough period, they fully pay off the loan voluntarily as most people don’t like the feeling of being in debt.

This is a major contributing factor to the limitations of APR.

Because when calculating APR, interest fees are assumed to spread out over the full term of the loan. The implication is that the longer the whole life of the loan stretches, the thinner the interest is spread out. Resulting in a lower APR.

APR can however be a good gauge for borrowers with a shorter time horizon.

For example, in certain cases a loan with a higher APR compared to another can actually be cheaper when the time frame is taken into account. Even though it has a higher interest rate, this can be due to it having a much lower administrative fee compared to the other.

This is another reason why when shopping for loans, borrowers should use interest cost as a comparison statistic rather than APR.

It would paint a more realistic picture of the cost of credit.

Problems with cash out refinancing

Cash out refinancing is one of the popular methods homeowners use to access home equity locked in their property.

It allows them to retain possession of the house and get access to funds for business and personal use.

A cash out refi is effectively a replacement of the existing mortgage with a new and larger one. A portion of the loan goes into the outstanding mortgage while the balance comes in the form of a term loan.

In such cases, APR can really go haywire as it doesn’t take into account the interest rate of the existing mortgage.

For example, let’s say a homeowner has a $100,000 mortgage at 8%. He intends to raise $20,000 cash via a second mortgage or a cash out procedure. If a second mortgage for $20,000 has an APR of 9.5% and the cash out refi for $120,000 has an APR of 9%, on the surface it can seem like cashing out would be the cheaper option.

But what APR ignores is that the borrower will raise the APR of the existing mortgage from 8% to 9% by going that route.

Going with a second mortgage can be the cheaper alternative even though it has an APR that appears to be more expensive.

So in such situations, homeowners should take extra care in being meticulous with numbers.

Adjustable rate mortgages (ARM) and APR

As everyone should know, adjustable rate mortgages only hold their interest rates for a period of time. The rate then refreshes after the adjustment interval.

In calculating APR for ARMs, the assumption rule is that index rates and spreads remain the same throughout the term.

Meaning that interest rates stay the same over the whole life of the loan. Bankers and financial analysts call this a “stable rate” or “no change” scenario.

This either uses a fully indexed rate (FIR) made up of index plus spread that remains constant, or in the case of wildly fluctuating index rates, can cause confusing APR.

Finally, it is important to be reminded that while annual percentage rate plays in important role in informing the public of the cost of credit, there are many limitations to how close a picture it paints to reality.

It can serve as a general overview of a loan. But unsuitable for using as a comparison metrics to compare one facility to another.