The effective interest rate (EIR) is the precise interest rate the borrower is paying after all fees and costs have been taken into account. The EIR is different from the annual percentage rate, or APR. The APR is generated from a precise calculation specified in Regulation Z of the Truth in Lending Act. The difference between the APR and the EIR is that the EIR takes into account the costs of points and fees. If the loan has no prepayment, points, or other fees, then the EIR is the same as the APR.

The EIR is important because it allows you to quickly compare rates from various lenders with various schedules and costs; the EIR allows you to choose the rate that gives you the lowest cost. To calculate the EIR, you must make a major simplifying assumption. Many of the fees associated with home buying are paid out-of-pocket, meaning that they do not come out of the loan. Other fees (like points) do come out of the loan. The assumption necessary for this calculation is that all fees come out of the loan. This is not an unreasonable assumption, especially if you assume you will pay back all out-of-pocket expenses with proceeds from the loan. Remember, the lender will retain the amount of the loan attributable to points when distributing loan proceeds, but the monthly payment will be based on the entire loan amount.