By Richard Thomas
Overview
Credit card debt is a standard feature of modern life. However, just what the single most important feature of a credit card--it's APR--actually means is not widely and properly understood. The APR is not the actual interest rate charged on the card, but instead is more like an estimate, and sometimes the real rate and the APR can be miles apart.
Misconceptions
The most common misconception regarding credit cards is that the annual percentage rate (APR) is the actual interest charged on the outstanding balance of the account. This is not really the case. The APR is actually an estimate of what the interest rate is or will be in the near future. Given stable conditions, the APR is at best a partial reflection of the real interest rate, which is the effective annual rate (EAR), but this is not always so. Unstable conditions can cause the APR to bear little resemblance to what the EAR will be by the end of a fiscal year. This makes "Effective APR" something of a misnomer. There is an APR and an EAR, but not a combination of both.
Function: EAR and APR
The main differences between the EAR and the APR are these: 1) EAR is not usually a recognized as a legal term, and it certainly is not recognized as such in the states where nearly all credit card companies are based (such as Delaware); 2) EAR does not include any one-time changes, such as front-end or late fees. It also does not include extraordinary circumstances, like those that may cause your interest rate to change, such as late payment, balance transfers or special offers.
Setting Interest Rates
The major factor in setting a credit card's interest rate is the interest rate charged by the Federal Reserve, the issuer's projections on future inflation and the issuer's evaluation of a customer's credit worthiness. Low interest rates, stable inflation and good credit history can result in a low interest rate on a credit card. For example, many Americans enjoyed rates between 9 to 12 percent in the late 1990's, a reflection of the economic conditions of the time. The same Americans are now in 2009 likely receiving rates of 15 to 19 percent on their credit cards, due largely to future projections for higher interest rates and greater inflation.
Warning
Credit card interest rates and minimum payments are also misunderstood, and this failure can result in substantially crippling long-term debt. For example, assuming a stable balance and all other conditions remaining the same, an APR of 12.99 percent over the course of a year's worth of compound interest is the same as an EAR of 13.79 percent. The result is that planning to pay down credit card debts by regular installments is usually faulty. In the case of a large balance, the difference of 1.5 percent can add up to hundreds of dollars per year.
Not All Bad
Credit cards are not all bad, and offer most consumers a ready source of credit. Despite the interest rates, which are always higher than those involved in personal bank loans, they can provide a useful tool for individuals or families seeking to make ends meet when faced with short-term financial difficulties. That is especially the case in the United States, where there is a very low rate of personal savings.
Credit Card Effective APR by aperfectcredit.com