What Rate Are You Paying?

Suppose that your credit card has an APR of 18%, is this the real rate that you are paying? The answer is NO and I will explain why. Credit cards require monthly payments, therefore the 18% APR (Annual Percentage Rate) is not the real interest rate that you are paying on your credit card, the real interest that you are paying is higher than the APR. The EAR (Effective Annual Rate) is called the real interest rate. To give you an idea of what I’m saying I will give an example.

Assume that a credit card has an interest rate of 18 percent APR, since monthly payments are required, the real interest that you are paying is 19.56 percent. In order to get 19.56 percent you have to do the following. Since a credit card requires monthly payments, you make 12 payments per year because there are 12 months in a year; therefore you have to divide 18 percent by 12 months to get the monthly percentage. If you divide 18 percent by 12 months you should get .015 or 1.5 percent. What does 1.5 percent means? 1.5 percent means the percentage you are paying on your credit each moth. So, in order to know what is the real rate that you are paying in your credit card you have to do the following: [1 + (.18/12)^12] –1 this should give you 19.56 percent (the real rate that you are paying on your credit card).

To conclude, whenever you receive a credit card offer with a certain APR, don’t assume that is the real rate that you will be paying. Before accepting the offer, find out what is the real rate (EAR) using the following formula: [1 + (r/m)^m] – 1, where “r” stands for rate, and “m” stands for periods in a year. For example, if the percentage is quarterly, then m is equal to 4, if the percentage is semi-annually m is equal to 2 and so on.