I've been working on constructing an Excel spreadsheet that will calculate an APR (for loans in the US). In researching which built-in formula to use, I've seen websites refer to the "effective rate," the "internal rate of return," and the APR. Could someone help me understand the difference between these terms?
Very quickly, the difference between them depends on which side you are coming from (ie as the lender or borrower).
From this source, I found these quick definitions:
Internal rate of return for a cashflow is the discount rate at which the net present value is zero.
Annual Percentage Rate (APR) is the lender's IRR for a mortgage.
IRR is what a lender would actually make on a loan, and is often applied as a standard, annualized way to compare investment returns.
APR is the rate charged to borrowers wanting to take out a loan. You see this most often on car loans.
The effective rate is what you are actually paying/getting payed. This website explains it's relationship to other rates. It looks like the terms are largely inter-changeable, but usage depends greatly on context.
Hope this helps!
Wikipedia gives effective interest rate as an alternative name for IRR. It lists two differences between APR and effective interest rate.
- the effective interest rate generally does not incorporate one-time charges such as front-end fees;
- the effective interest rate is (generally) not defined by legal or regulatory authorities (as APR is in many jurisdictions)
There are two further differences between the IRR and APR. One is that IRR is the rate taking compounding into account, while APR does not take compounding into account. The other difference is the focus: APR is generally the input, while IRR is the output. That is, with APR one is given a rate, and uses it to find the payments, while with IRR one is given the payments, and uses them to find what rate corresponds to the payments. Because of this, it's possible for there to be more than one possible IRR, if two different discount rates result in the same set if payments.