What does apr mean?

[carrottop]

What, exactly, does apr mean? I know it means annual percentage rate, but what does that mean exactly? Is apr different that interest rate, and if so, how is it different? How are the two calculated and what is the difference? I'm just a bit confused as to why there is a difference between apr and interest rates.

[mholl95]

The APR (Annual Percentage Rate) is an interest rate, but it attempts to convey the true percentage you'll pay on a loan amount for the year by taking into account a number of factors such as the monthly payments, fees, service charges, and other costs that are likely to occur over year. In this case, it's called the effective apr. You'll find that some organizations may calculate this rate differently.

But, if there are no added factors or variables attached to the calculation, then it's called a nominal apr, meaning that it's a simple interest rate. For example, 10% of $100 being $10. Nothing else is taken into account.

So an "interest rate" doesn't really take on a whole lot of meaning until it's put in some perspective. For example, is it a simple interest rate, compound interest rate, annual percentage rate, etc.

cheers
Michael

[carrottop]

So when people say "APR" which of those APRs are they talking about?

[mholl95]

Typically, you'll be quoted the nominal apr. But your effective apr will be a bit higher once you factor in fees, penalties, etc., and how the company calculates the interest on your outstanding balance. Many will use what is called a daily periodic rate. The daily periodic rate is the nominal rate divided by 365 days. The dpr is what causes a compounding effect, meaning that you'll be piling up new interest charges on the outstanding balance, existing interest, and other costs much faster. Of course, if they use a monthly periodic rate (nominal apr divided by 12), then your effective rate would in essence be the very close to your nominal rate. The key is the compounding method that they use and really don't like to discuss. (So read their small print.)

For example, you could be quoted a nominal rate of 15.9% on a credit card, but once you factor in the other variables and the dpr compounding, the effective rate could be 18% or more. That's why it's important to pay your balances off quickly. So someone who just pays the minimum balance on their credit card every month is, most likely, paying an effective rate that is through the roof.

Another way to think about compounding is what you'd prefer to get if your money was in an interest bearing savings account. Some accounts might offer monthly compounding, quarterly compounding, or semi-annual compounding. You'd want monthly compounding because that's how often your account would earn interest, including interest on existing interest you've earned.

Compounding is beautiful thing, except when credit card companies use it to hilt for their benefit.

I've tried to explain it without getting into the ugly math, so I hope it helps. Again, any time you're quoted an APR, dig into the details to find out how they actually calculate the monthly balance.

cheers
michael