USAinDebt

Everybody (hopefully) knows already that APR stands for Annual Percentage Rate. So far so good, but then the next question is: “What is an Annual Percentage Rate?”

Consumers often think that the Annual Percentage Rate is the cost of credit per year. It includes interest and other finance charges. APR is commonly used to compare loans from different lenders, but don’t be fooled - your APR does not regulate your monthly payments, and a lower APR does not necessarily mean a better deal. Your APR does not reflect you real interest on a credit card loan. Your bank is actually charging you by an Effective Interest Rate, which is a result from the compounding interest on a credit card. It is important to know how your credit card company calculates your finance charge. Most companies calculate using the daily periodic rate, and less companies go by the monthly periodic rate. If the daily periodic rate is used, your APR is divided by 365, and then multiplied by the average daily balance. If a monthly periodic rate is used, your interest is calculated by dividing your APR by 12, and then multiplied by the sum of the average daily balance for the month.

Compounding Interest Formula:

P is the principal (the initial amount you borrow or deposit)
r is the APR
t is time in years
n is the number of compoundings per year
A is  total amount to be paid back for a loan (Principal + interest)

When the interest is compounded once a year:

A = P(1 + r/n)^nt

Here’s an illustration of what difference monthly vs daily compounding makes.

Let’s say that you have the following loan situation:

P = $10,000 (that’s what you initially borrowed)
r = 20% (this is your APR)
t = 5 (this is the period that you took the loan for)
n = 12 (monthly compounding)

Your A (total amount to be paid back) is 27,012.79

Now recalculate this if you have a daily compounding:

P = $10,000 (that’s what you initially borrowed)
r = 20% (this is your APR)
t = 5 (this is the period that you took the loan for)
n = 365 (daily compounding)

Your A (total amount to be paid back) is 24,899.73

To make it even more complicated, banks have different types of APRs.

First of all, you can have either a fixed APR or a variable APR. The fixed APR usually doesn’t change or rarely changes. It will fluctuate if you credit score changes. The variable APR changes more frequently - it depends on the Prime Rate (the interest rate that commercial banks charge their most creditworthy borrowers, it is established by the Federal Reserve Board).

Then there is a purchases APR, cash advance APR, Balance Transfer APR, Introductory APR, Default APR.

The purchase APR is what you banks charges when you swipe or shop online and you don’t use your PIN number.

Cash advance APR is usually higher, accompanied with fees and it’s in effect when you take cash advances from your credit card. By the way, if you take a cash advance, when you are paying off your credit card, you will be paying the purchase balance first, not the cash balance.

A Balance Transfer APR is usually lower, it sometimes has fees and it’s used when you are paying off one credit card with another, e.g. “Balance Transfer”.

Introductory APR is usually given for a short period of time, to attract customers with a low or 0% rate, after the trial period expires, you regular APR goes in effect.

A Default APR is something that you don’t want to do: you bank will penalize you with a default APR if you are late or miss payments, if you go over you limit or you miss a payment on another credit card or any type of a loan. That’s right, a credit card company can raise your APR if you didn’t pay your phone bill. Remember, the phone company and your bank are looking at the same credit report!

The power of compounding was said to be deemed the eighth wonder of the world - or so the story goes (Albert Einstein).

Interest calculator by gomath.com

Tags: apr | credit card | compounding interest | interest | eir | periodic rate | cash advance apr | balance transfer apr | introductory apr | default apr