Tuesday
May052009
APR vs. EAR: Realistic Credit Card Comparisons
Tuesday, May 5, 2009 at 11:50AM
We all know that the most appropriate way to utilize a credit card is to pay the balance in full each and every month. If you do that, then great you can stop reading now. However, if you do use credit cards that carry a balance then you should do some comparison shopping and pick the best card for your situation. In this case I don’t mean which one has the best “Points” or which one lets you put Jr’s picture on the front. Instead, let’s talk about how to realistically calculate what you will be paying the card company.
Credit Card companies are known for their fine print and sometimes questionable lending practices. Whether or not they could be considered predatory could be the topic of a post on its own. One of the questionable things they do, is to only disclose the APR of a given card and legally that is all they are required to do. In fact, anytime you secure a loan the lender is required to state in clear terms the APR, or Annual Percentage Rate, for the financing.
I want to introduce you to a new term; Effective Annual Rate (EAR). The EAR is a more accurate representation of what you will be required to pay back. An APR gives you the Annual or Yearly interest rate. If you borrow a $100 at 12% APR then you would expect to pay back $112. This is accurate if the interest is “Compounded” or calculated annually (yearly). Most consumer loans though require payment monthly, which means interest is compounded monthly. Using the $100 example above, if compounded monthly you would have paid back $112.68 at the end of the year. Sixty eight cents may seem a trivial amount, but when dealing with larger numbers the difference can be significant. The 12% APR is actually 12.68% EAR.
When comparing credit cards, you need to check two important pieces of information. The stated APR and the compounding frequency. Many cards compound monthly but some may also compound weekly, which will result in a higher EAR and a higher pay back amount. To calculate the EAR for a card you can use this formula:
EAR = ( 1 + APR / M)^m – 1
APR = Stated APR (rate)
M = Compounding Frequency (12 for monthly, 52 for weekly)
Our example above would look like this:
EAR = (1 + 0.12/12)^12 – 1
Which gives us 12.68%
Using the steps above you now have a realistic and fast way to compare the actual rate that you will be required to pay back.
Credit Card companies are known for their fine print and sometimes questionable lending practices. Whether or not they could be considered predatory could be the topic of a post on its own. One of the questionable things they do, is to only disclose the APR of a given card and legally that is all they are required to do. In fact, anytime you secure a loan the lender is required to state in clear terms the APR, or Annual Percentage Rate, for the financing.
I want to introduce you to a new term; Effective Annual Rate (EAR). The EAR is a more accurate representation of what you will be required to pay back. An APR gives you the Annual or Yearly interest rate. If you borrow a $100 at 12% APR then you would expect to pay back $112. This is accurate if the interest is “Compounded” or calculated annually (yearly). Most consumer loans though require payment monthly, which means interest is compounded monthly. Using the $100 example above, if compounded monthly you would have paid back $112.68 at the end of the year. Sixty eight cents may seem a trivial amount, but when dealing with larger numbers the difference can be significant. The 12% APR is actually 12.68% EAR.
When comparing credit cards, you need to check two important pieces of information. The stated APR and the compounding frequency. Many cards compound monthly but some may also compound weekly, which will result in a higher EAR and a higher pay back amount. To calculate the EAR for a card you can use this formula:
EAR = ( 1 + APR / M)^m – 1
APR = Stated APR (rate)
M = Compounding Frequency (12 for monthly, 52 for weekly)
Our example above would look like this:
EAR = (1 + 0.12/12)^12 – 1
Which gives us 12.68%
Using the steps above you now have a realistic and fast way to compare the actual rate that you will be required to pay back.
tagged APR, Credit Cards, EAR, Finance in Investing, Money Folders, Personal Finance
APR, Credit Cards, EAR, Finance in Investing, Money Folders, Personal Finance
Reader Comments (2)
As Health is wealth but i think money is wealth and world so we must hard work to get it therefore i read the article and found the nice tips which are useful for us
i used this post at night when i think about my friends and family so i really thankful for providing very knowledgeable information for further help
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In my humble opinion, credit cards are a necessary evil, wouldn't you agree? With out them you can't reserve a hotel room, rent a car and so on.
I belive its entirely up to the individual to be aware of the APR or the ( EAR ). You have to have situational awareness and responsable spending. I