Carleton, Inc.
Consumer Lending Software

The Interest Rate and the APR

One question we field on a weekly, some weeks daily, basis revolves around the Truth-in-Lending APR disclosure in the "fedbox" being a different value than the originating interest rate. A different value meaning the interest rate was 10.00% but the disclosed TILA APR is 9.98%.

The view in the consumer finance industry that "the APR and the interest rate should be the same if I don't have any fees" is not only predominant but has reached an urban legend type of status. Too many times the answer to my inquiry as to why the above statement is true has been "because it is". Sound logic.

In reality, the two rates are truly distinct values. They have separate purposes and functions. One is to compute the interest charge for the transaction according to the lenders choice of accrual that is in step with their particular philosophies and policies; the other is to measure the cost of credit in a standardized fashion in an attempt to provide consumers with a yardstick in comparing competing deals.

The interest rate is the dominant factor in determining a loan's magic number; the monthly payment. The prospective interest plus the loan principal determine the scheduled total of payments.

Once the payments and all the other disclosure numbers have been computed, then the Truth-in-Lending APR can be accurately computed and disclosed. It is entirely a back-end number. It is often erroneously thought that the APR creates or drives other loan values, but it does not. It merely measures the result of the other computations and provides a common barometer for the consumer to evaluate and compare credit deals.

The changing nature and operations of the lending industry has brought the differing characterstics of these rate values out into the light. For many years the TILA APR produced a rate that was always the same value as the interest rate and it still will on occasion. But in particular, the advent of "simple interest" transactions with daily interest accrual has changed the landscape dramatically.

Back in the day when interest was nearly always computed on a monthly basis, aka "360 day year", the APR and the interest rate, in the absence of pre-paid finance charges, would end up the same value.

That is because Regulation Z mandates that the APR be computed on a "unit-period" basis. (We'll disregard the U.S. Rule implications here; that is another entire blog that could stretch for several city blocks) So when repayment terms on loans were predominantly monthly in the industry, both the interest charge and the APR were computed monthly. A 10% interest rate would work out to be a 10% APR. Most of us who have been around this industry for 20 years or so remember that "it was always that way".

Think about today's lending practices and the prevalence of "simple interest" transactions. One of the hallmarks of simple interest is computing the interest charges on a daily basis. Each calendar day between scheduled payment dates accrues interest at 1/365 of the annual rate. So, that daily interest produces a dollar interest charge that, in the absence of fees, becomes the TILA finance charge by definition.

When the APR recognizes that loan's total dollar charge, it assumes time periods are monthly and computes an APR accordingly. Interest computed daily and an APR computed monthly are not "apples and apples".

However, remember that one of the roles of the TILA APR is to standardize the cost of credit rate and provide a "level playing field" gauge of the credit cost regardless of differing parameters, such as interest accrual, employed by differing lenders.

If the dollar interest charge for 36 months on a daily basis is greater than the dollar charge for 36 months on a monthly basis, it only makes sense that the APR would be higher.

It is not unusual for a 14% interest rate computed on a daily basis for a monthly loan to yield an APR of 14.02%. Both rates are accurate, they simply operate with different rules.

One important caveat for lenders with a policy of operating at state maximum interest rates is recognizing when the practice of daily interest accrual may produce an APR that exceeds the computational rate. Many states have statutory language that equates the maximum rate with the TILA APR. Some states regulate interest and some the equivalent of the TILA finance charge. Like so many things in today's world, what used to be simple isn't necessarily so any longer.

Posted on Apr 25, 2011