How Does APR Work on a Credit Card?

by Edwin Thomas ; Updated September 11, 2017
How Does APR Work on a Credit Card?

APR is Not the Real Interest Rate

The usual misconception with credit-card Annual Percentage Rates (APRs) is this number is the actual interest annually charged for the account. It is not. In annual terms, a credit card's APR merely is an estimate of what the interest rate is or will be in the near future. Even given stable conditions, the APR is just a partial reflection of the real interest rate, Effective Annual Rate (EAR). Unstable conditions can result in the APR having little resemblance to what the EAR will be by the end of a fiscal year.

APR in Practice

The APR on a credit card usually is an expression of the interest on the credit card if it were compounded daily, not annually. Given stable conditions, an APR of 12.99 percent compounded for a year is the same as an EAR of 13.88 percent. But some credit cards are compounded monthly instead of daily. Then math would convert a 12.99 percent APR into a 13.79 percent EAR. The difference might only be between 1 percent and 2 percent, but that can add up over time, especially when carrying a high account balance.

Why APR and not EAR?

EAR is what is commonly imagined when it comes to interest rates because something similar is applied to most loans with fixed payments, such as mortgages and car loans. It is not applied to credit cards because it is not a legally recognized term in many states, especially the two where most credit card companies keep their headquarters: Delaware and North Dakota. The legal definition of APR is structured to favor the somewhat misleading approach to interest rates used by credit card companies

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