The Dreaded Credit Card APR

Posted on November 13, 2009
Filed Under Credit Cards

APR (otherwise known as Annual Percentage Rate) is that mystical number credit card companies tack onto their credit card bills. It’s the interest charges you pay if you don’t pay your outstanding balance in full each month. In short, it’s the amount of money your card company makes in return for extending you the credit in the first place.

Now there’s nothing wrong with making a profit, and card companies are entitled to be reimbursed for their risk and the service they offer allowing you to purchase items so easily. But the credit card APR has transformed over the years from being an easy-to-understand financial charge into a mere label that masks a complex calculation constructed to hide cost and promote confusion. And that is wrong.

You see, credit card companies use different formulas for calculating the interest and finance charges you owe on your bill each month (unlike prepaid debit cards that charge no interest). So the APR only tells a very small part of the overall debt story. Which particular formula they use is based primarily on what is most beneficial to them – not you the consumer. In most cases they start with your APR and divide it by 12 for each month in the year. Then they multiply that number (known as the Periodic Interest Rate) each month by whatever they determine your monthly balance to be. The result is your monthly interest charge. How the different variations on that formula have evolved is pretty eye-opening.

Simple Interest – Simply

In the beginning, interest was simple, hence the term “simple interest.” You didn’t need a credit card APR calculator to figure out what you would owe. Let’s say you borrowed $2,000.00 for a 1 year period and the interest charge was 5%. That meant you would pay 5% of $2,000.00 for the privilege of borrowing the money, that’s $100.00. So when you paid off the loan, you paid back a total of $2,100.00. This is the interest calculation that’s the easiest to understand and the most beneficial to the borrower. For that reason it hasn’t been used in the credit card world since the advent of store credit cards.

Compound Interest is Born

A more beneficial way to calculate APR card credit APR is to use compound interest. This is interest that’s added back onto your original balance to create a larger balance and thus more interest. In our $2000.00 example, our monthly interest would be added to the balance each month to create a larger balance and at the end of the year we would end up paying back $2,102.32. The difference seems small in this example, but it grows substantially larger when the interest rate is higher and current credit card interest rates are bobbing well above the 24% level nowadays. Credit card companies have been using compound interest for many years now to add to their bottom line.

Tweaking Your Balance

Exactly when the compound interest is applied makes a huge difference in the amount of money you owe on your credit card bill (and the amount of money your bank or credit card lender stands to make). And so, different variations of the monthly balance calculation came into being. Not surprisingly, each variation was more advantageous to the lender.

At first balances were adjusted each month (“adjusted balance”) by subtracting any payments you made during that month. That in effect lowered your balance a bit and your interest calculation was smaller, more favorable to you. This didn’t last long all things considered.
Next, companies began calculating the periodic interest rate on the balance you had at the beginning of the month. They stopped subtracting any payments you made during the billing cycle. This creates a larger monthly balance than the previous method and more interest for the credit card company too.

When it became apparent that many consumers were increasing their credit card balances each month by spending more and more with their cards, banks found that calculating interest based on your ending balance was more beneficial for them. So that became the next little trick in their trick bag.

But what about consumers that actually reduce their credit card debt in a month by making a larger payment? If a lender uses the ending balance method, they’re losing some money. Well, enter the “average daily balance” calculation. In this method, the individual balances of each individual day of the month are added together and then divided by the number of days in that month. That yields an average for the month that’s higher than the ending balance – so no more lost profit.

Then there’s my personal favorite, the two cycle average daily balance. With this method the credit card lender takes the individual balances of each individual day of the last two months, adds them together, and then divides that by the number of days in the two-month period. The result is an average for the two-month period. This calculation method is designed to counteract consumers who consistently try to reduce your credit balance from month to month. This calculation effectively means you’re paying interest on debt and charges that you already paid for. I’m sure whoever thought this one up got a promotion and a corner office.

The Grace Period Two-Step

Banks and lenders have played with the grace period too. In the past virtually all major credit card companies offered a generous grace period each month of around 25 days during which you could pay your bill in full and avoid paying any and all interest. But the more people that take advantage of that period, the less interest income the companies made and so, over time, that grace period began to shrink. Some companies in fact offer no grace period at all. This means that their credit card customers pay interest on every single thing they purchase with their cards because the moment the transactions clear, interest starts accruing.

The Credit Card APR Bait and Switch

Another way the APR has transformed over the years from a simple financial charge to much more complex concept is illustrated by what some people call the APR bait and switch. You’ve seen the ads. You know, the ones that guarantee a very low “introductory” rate on a card if you just switch your balance over from another credit card. Sometimes they guarantee a low credit card APR and sometimes they guarantee the lowest apr credit card rate of all – zero. But the truth is that the rate is only temporary and it comes with all sorts of strings attached.

In many, many cases there are a number of ways for you to default on the rate unless you’re very careful. For instance, you can pay your bill one day late (even 1 minute late) and your rate will change, often skyrocketing into the 25% range or more. In some other cases, you may pay some other bill late (like another credit card bill or even your utility bill) and your rate will skyrocket taking you from the best credit card APR to the worst in no-time. And maybe also sending your credit in the opposite direction (see Bad Credit and Debit Cards).

In this manner the APR is used to lure you into the credit company’s web. They use a simple number that most folks think they understand to entice you into changing over to their card. They’ll disclose all of the details of the deal but that will be in very fine print buried in a small folding pamphlet that comes with your card. If you’re not disciplined enough to study it, you wouldn’t know about all the provisos on your account. And if you’re not disciplined enough to pay on time and behave, you’ll end up with a much larger bill each month than you planned for.

Interest Rate Bloat

To safeguard themselves against a changing economy, credit card vendors have moved from a fixed interest rate to a variable one. This ties your rate to some financial index that fluctuates when the economy does. A popular way to determine rates is to base them on the Prime Rate which is the rate of interest that the big commercial banks charge their best customers. Then a bank will add a certain percentage on top of that and voila, you have your interest rate.

It’s impervious to economic downturns because it always keeps pace with inflation and that’s good for the banks, not the credit card holders. And to add insult to injury, banks have often added even more increases to rates for individual customers who haven’t been absolutely perfect in their payment records.

All in all, the credit card APR has been much more of a moving target than most consumers realize. On the surface it looks like an easy way to compare between credit card offers and to estimate what your costs and payments might be. But when you peel away some of the surface, you see there’s a lot more to it. You need to be careful, you need to be disciplined, and above all you need to continue to educate yourself about all the aspects of credit card borrowing and continue to ask questions. For instance, should you have more than one credit card? Should you keep any sort of balance on your current cards? And is a credit card even right for you at all or would you be better off with a prepaid debit card? Understanding credit card APR is important, so stay curious and read, read, read – it’s your best defense.

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