Term: Annual Percentage Rate (APR)

The Term: Annual Percentage Rate (APR)

APR is something everyone runs into pretty early into adulthood but few really think about. It’s applied to loans, credit cards, and savings accounts, and is the source of a lot of confusion and aggravation. To add to the confusion some people are given ‘variable APRs’ that can change every day. Jees! We'll handle variable APRs in another post.

The Annual Percentage Rate is the total rate that your debt will generate additional debt in a given year.

I’m going to use a term called ‘the box’ when we go into territory where only the things I say matter. In the real world there will be other considerations but ‘the box’ allows me to set the rules so that other things don’t interfere and make the situation more complicated.

The Box

So lets take a quick vacation to ‘the box’ and say you got a credit card with 15% fixed APR. That 15% APR works out to 1.25% per month that you ‘carry a debt’, meaning you don’t pay it off in full.

One day you’re cruising through the mall and notice some cool stuff you can’t live without, an Apple laptop ($1500), an iPad ($600), a new XBox 360 ($250), some assorted jewelry ($600), a new table ($1000), and a shopping spree at Express ($1050).

The important part is you’ve wracked up $5000 in purchases on that 15% card all in one day and now you decide that you’ve had enough and go home to enjoy all this cool stuff you purchased.

A month goes by and you don’t pay by your due date and ‘carry’ the debt over. Your credit card company says "Hey, remember that money we loaned you? You’re paying for that privilege. We’re charging you an additional $62.50 (1.25%) of your $5000 loan and you now owe us $5062.50."

Holy crap! You just got nailed for $60 for nothing. That’s like, 2 nice meals. 3 bottles of decent wine. That’s 30 bottles of water. That’s a new shirt! Why did you carry that debt? Ah hell you’ll deal with it next month...

Another month goes by. The credit card company comes back again. "Hey man, you still didn’t pay. Here’s another $63.28. You owe us $5125.78".

What? Why did it go up? Because you didn’t pay off that original amount, now they assess your additional debt on top of what you actually charged.

Imagine if you had three times that amount, $15,000 weighing you down. Now your monthly interest charge is $187.50. You’re being charged almost $200 dollars a month just for the privilege of using someone else’s money in the past. Just to break even you have to pay $187.50, even more to start paying it down.

So as you can imagine, those APRs can be killer. If you are younger or have a bad credit score you could be saddled with APRs of over 24% (2% a month)!

How to determine the amount you’ll be charged:

(Note: Example APR as decimal: 15% would become .15)

Cost of Carrying a Balance = (APR as decimal / 12) * Balance

Why APR?

Why indeed! The Federal Government wants you to be able to understand financial matters in a big overarching way. This levels the playing field when it comes to percentage rates, making many kinds of financial decisions pulled back into the fold of APR. Your savings account figures are generally in APR (though it's called your interest rate), so are credit card rates, personal loan rates, mortgages, car loans, etc.

The idea is once you understand APR, you understand the way most financial engines operate. Once that's handled, you can start making informed decisions about your financial future. Unfortunately, most people learn this lesson a little late, after they've already signed up for bad loans with high APRs.

Here's hoping you avoid learning from the school of hard knocks!