Credit Card APR Explained

The single most important number related to your credit card account is the Annual Percentage Rate, which is the interest you pay on your accrued balance. High interest rates can be deceptively expensive. Here's how you can calculate the true cost of your APR.

Calculating Your Actual Rate

Let's use as an example an APR of 19.9%, which is fairly standard for people without stellar credit -- who, ironically, are the most likely to need a credit card to plug day-to-day holes in their budgets.

The advertised APR of 19.9% states that, over the course of one year, you'll pay an extra 19.9% on any purchase -- that is, you'll pay $19.90 in interest on a $100 purchase. This, however, can be deceiving. 19.9% is a simplified total of what is actually a daily interest rate, which can be calculated by dividing by days in the year: i.e., 0.056% per day. This daily rate is compounded, which means that the interest owed yesterday is itself generating new interest fees today. Your effective interest rate is actually 22% per year. (Mathematically, this is calculated as follows: (1 + (0.199 ÷ 365))^365; the carat means "to the power of" and is shorthand for multiplying that number times itself 365 times.)

Added Fees Add Up

This effective APR can be pushed even higher if your card charges you regular fees; a monthly charge of $10 per month, for example, becomes part of your accrued debt. You might think of $10 per month as $120 per year, but after interest you'll actually owe $133.93 at the end of one year, and $297.34 at the end of two years. The longer you allow the interest to compound without paying it off, the more expensive it becomes.

The High Cost of Overspending

It is useful to know how much one dollar of expense is actually going to cost you. Most importantly, if you always charge more to your credit cards than you are capable of paying, your cost per dollar is effectively infinite: you'll never catch up to this debt.

The High Cost of Past Debt

But consider what happens if you're only treading water: let's assume a $500 balance in January. You charge $50 one month, and $150 the next; meanwhile, you can afford to pay $100 a month on your bill. At the end of two years, your balance will be $780.78, even though you've paid off all of your new charges in that time -- the cost of that initial $500 worth of goods is now 56% more than it was when you bought it.

The solution is as simple as it is difficult: always charge less than you can afford to pay. If you pay $120 per month on that same bill, your balance will be $195.87 after two years, and you'll only be nine more months away from paying off the bill entirely.

Spend Less Than You Can Afford

Put another way, your initial $500 splurge will take you 33 months to pay off, over which time you'll have paid $3,957 for $3,750 in total charges. Some purchases might be worth this extra money, but the wise money manager will be very reluctant to buy something that they'll have to pay off over a long period of time.