Most people know that APR stands for "Annual Percentage Rate" and that APR is the most important metric that consumers look at when shopping for credit cards. But what does APR really mean and how does it affect your bottom line?

We'll start off with a definition, "Credit Card APR is an expression of the effective interest rate a borrower will pay on the outstanding balance of a credit card". A little wordy but it's a good start. Sounds pretty simple and somewhat self explanatory right? Annual = yearly and percentage is the percent of the interest charged. So if I carry a $100 balance on a 8% ARP card for a year I'm going to pay a grand total of $8 in interest right? Well, err.... no.

Savings Account Analogy

To explain why your APR is not the total amount of interest you'll end up paying on your credit card, let's use an example of a saving account, the antithesis of a credit card :)

Say we deposit a $100 into a savings account at the beginning of the year. The bank says that it'll pay us 8% APR but paid every six months. So at the end of June we get 4% on our $100, $4 so now we have a $104 balance and on Dec 31st we get another 4% on our BALANCE, so that's $4.16 we get paid, bringing our grand total of interest paid by the bank to $8.16. So you actually got paid an effective rate of 8.16% not 8% due to the fact that mid year your balance went up due to the interest payment they made to you. So for half the year you were getting interest on $104 not $100. So if the APR is 8%, the amount we really got back was $8.16 and is know as effective interest rate.

Anyone who's ever taken even an elementary lesson in finance will recognize this phenomenon as our friend (or foe) compound interest. In the case of savings we can see how it helps us. We've all played around with spreadsheets and have calculated how if we put away $100 per month for the next 1000 years @ 5% interest we'll end up with billions of dollars, even though will of been pushing up the daisies for 900 of those 1000 years!

So without getting into too much math we can see the opposite effect when looking the savings account evil twin, the credit card. Due to the effect of compound interest, the actual interest rate you'll end up paying on a, the effective interest rate, on a 8% APR card with the same terms above will actually be 8.16%. But the suits at the credit cards companies actually want you to pay monthly not bi-yearly so you'll end up paying even more!

Monthly or Daily Periodic Rate

In reality, the credit card companies have two time periods they calculate your interest over, the Monthly or Daily Periodic Rate. A card that uses the monthly periodic rate will have a lower effective interest rate than one using the daily periodic rate assuming all things being equal.

Summary - 'tis all about the Effective Interest Rate!

Be aware that APR is not really the final amount of interest you'll pay, and you'll always end up paying more in the end. Obviously, with lower interest rates and a small balance the differences are not going to be as dramatic than at hight interest rates, and with very large balances. So read the fine print and find out what the effective interest rate is.

Math for the nerd in you - Calculate EIR - Effective Interest Rate

Math or Maths is fun, here are some formulae to chew on for the more mathematically inclined:

n = number of time the interest is paid a year. (eg 12)
i = your effective interest rate
apr = your quoted interest rate (eg 12%)

n = number of time the interest is paid a year.

i = your effective interest rate

apr = your quoted interest rate

i=100*( [1+apr/(100*n)]n-1)

Ok so Apr calculated monthly converted to what you'll really pay are:

8% is really 8.3% (8.33% compounded daily)
15% is really 16.18% (16.18% compounded daily)
25% is really 28.07% (28.39% compounded daily)
33% is really 38.48% (39.08% compounded daily) yikes!

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