Annual Percentage Rate (APR)

• Pages: 48-49

Page 48

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. Its purpose is to allow consumers who are shopping for credit to compare different offers on the same basis, to compare apples with apples. In the absence of legal requirements to clearly state interest rate calculations on all loan contracts, it would be possible for a lender to misrepresent the interest rate of a loan through the use of different compounding periods. By insisting upon a clear statement of the APR on loan contracts, the truth in lending law has gone a long way towards eliminating interest rate confusion. However, the APR can be calculated in different ways and can sometimes cause rather than eliminate confusion.

LOANS AND INTEREST RATES

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.

Page 49

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 lending 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...