When consumers borrow from a financial institution (for a loan or a mortgage), they pay interest. APR denotes the total cost of borrowing, which includes not only the interest but also other charges and fees that the lender demands from the borrower. A lender may offer a lower interest rate but have higher upfront costs (e.g. the myriad closing costs when buying a home). When all costs are taken into consideration, a lower interest rate loan may actually turn out to be more expensive. APR is the effective interest rate you pay when you factor in all the costs. So it allows the borrower to make a more apples-to-apples comparison of all lenders.
edit Example of Difference
Suppose the principal amount of a loan is $200, the interest rate is 5% and transaction costs and fees are $6. In this scenario, the borrower will effectively get a loan of only $194. At the end of 1 year the interest paid will be $10 (5% of $200). This interest payment of $10 is 5.154% of $194. Therefore, the effective rate that the borrower pays (a.k.a. Annual Percentage Rate, or APR) is 5.154% even though the nominal interest rate is 5%.
edit Why APR is used
Due to transactions costs and fees, the APR is always higher than the nominal interest rate. Therefore, APR represents the "true cost" to the borrower, and is a better measure of the cost of borrowing.
Another advantage of APR is that it allows the borrower to better compare the cost of borrowing from different lenders, since they may all have different fee structures. It is quite possible that a lender may charge a higher interest rate but a lower fees. This may be a better deal than a lender charging lower interest but high upfront transaction costs. Since APR factors these costs in, the comparisons between lenders are fair and accurate.
While in theory APR should make it easy for borrowers to compares loan offers from different lenders, in practice things are a little more complicated. This is because the in Lending Act requires lenders to include certain fees in their APR calculations, but some of these are optional to include. Different lenders calculate APR differently. What's more, the closing date they assume also impacts APR calculation.
Fees almost always included in APR:
- Points – both discount points (money paid upfront to reduce the nominal interest rate) and origination fees
- Various administrative fees that a lender charges a borrower to recoup the cost of doing business e.g. Underwriting fee, loan processing fee, document prep fees and commitment fee
- Certain Title fees, like insurance and closing
- Attorney fees
- Mortgage insurance premiums (either private or for FHA loans): These are premiums the borrower needs to pay to insure the lender against the risk of defaulting
- Prepaid interest – Interest that is paid from the time that you close to the end of the month. Different lenders calculate the number of days differently, based on the closing date or other "rule of thumb" criteria. So this amount may vary by hundreds of dollars even with the same interest rate.
Fees sometimes included in APR:
- Application fee
- Tax related service fee
Fees usually not included in APR:
- Appraisal fee
- Credit report fee
- Title fee
- Recording fees
Given the variances in what fees lenders include in their disclosed APR, borrowers need to carefully evaluate loan offers to choose a loan that is best for them.
edit APR vs. Interest Rate: Video explaining the difference