APR — The Cost of Credit Card Ownership
The main way that credit card companies make money is by charging interest on any outstanding balance left on the credit card. Customers who do not pay their outstanding balance in full by the due date as stated in their credit card statement owe interest on the outstanding balance (such customers being known in the industry as 'revolvers'). Also, if you have an outstanding balance and you pay a large portion of it in one month the interest charged is on the total outstanding balance rather than the balance less what's been paid. For example if you have a balance of $1500 and pay $1000 this would leave $500 unpaid. However, you would be charged interest on $1500 not $500. The ammount of interest paid is generally expressed in terms of APR (Annual Percentage Rate) which is effectively an average of the ammount of interest a card user would be expected to pay over a year. We'll look into APR in a bit more detail below.
What is APR
The acronym APR stands for Annual Percentage Rate; however pinning-down what these words means is a little more complex than this simple acronym might at first suggest.
Credit card companies levy interest charges monthly. Each month the amount of money an individual owes can go up or down, thus determining the APR is a bit of a fudge. The charge levied each and every month needs to be both accumulated and averaged out over a year. If this sounds complicated, then it is! The actualy calculation is based on the present value rule which is given below:
Where P is the Present Value, A is the ammount of any future payment, t represents the number of years for which the loan is due to last (the repayment period) and r is the rate of charge. For a monthly payment system such as a credit card then an expected repayment amount is first determined (usually just above the minimum repayment). The value of A is set to the minimum repayment each month and t is set to 1/12 for the first month, 2/12 for the second month etc. This results in a complex equation where the equation above is summed twelve times and the value of r can be calculated. This, essentially gives the APR — easy, right! What this does mean is that the APR calculation is a bit of a fudge and most people will actually be paying more than this in interest charges. You see, the APR value actually represents a baseline average of charges for a given card. If you have a large outstanding balance you will actually be paying more than this.
As a result the APR can have a significant effect on your ability to pay-off any debts accumulated on your card. To make matters even more complex the APR can not only vary from card to card but may also vary dependent on how you use your card!
Probably the worst offender here is if you obtain a cash advance on your card (and this means any form of cash advance, even paying for travellers cheques or foreign currency). Not only will you often be charged a cash advance fee (usually 1–3% of the total) but you may also be charged an APR as high as 26%. This is a good reason why it's better to use credit cards only for emergencies or to buy items that you fully intend to pay for in full at the end of the month.
Tiered APRs
Many card issuers will also vary their APRs dependent on how much money you've borrowed on your cards. With these types of cards a small balance may have an APR of 14% but once you're over a certain threshold (often about $2500) the APR shoots up to 18%. Always read the fine print on card application forms as these card types are best avoided.
Penalty APR
Many card issuers will levy what's called a penalty APR. If you frequently (often this only means more than once) pay your card bill late your APR may be raised, which affects your entire card balance. The lesson being: make all your payments on time.
Intorductory APR
This represents the most prevalent marketing ploy in terms of attracting new customers. The card is offered at an introductory low APR for a limited time (which can be up to a year). After this the APR increases to the standard level for the card. This type of offer can be advantageous if you have a large outstanding balance as it can help you pay-off what you owe.
Conclusion
The main point here is that you should pay attention to your card's APR as it is this that determines how much you will be repaying. Also note that the APR is a guideline only; depending on your personal circumstances you may actually be paying far more than the headline APR suggests you should be.