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Ask anyone what interest rate is their credit card charging them and they will answer with
the apr. While the apr is the rate used to determine your finance charges, it is not the
true effective interest rate. In fact, it is always higher than the quoted apr.
Here is an example to illustrate how to actually calculate the the effective interest rate.
Let us assume you have $100. You deposit it in a bank for one year, who promise to pay
you a 10% interest once a year at the end of the year. Hence, at the end of one year,
the bank will pay you 10% X $100 = $10. You will get back a total of $110. You return for
putting your $100 in the bank for one year is $10, which is equal to 10%. In this example,
your efffective interest is 10% (same as the quoted interest).
What happens when the banks says they will pay you 10%, but will pay you semi-annually (ie
twice a year).
So let us assume you deposit $100 with the same bank on 1st January. On
30th June, they pay you 5% x $100 = $5.00. (It is 5% because they will spit the 10% payment
into half). So now you have a total of $105. On 31st December, the bank will pay you
5% x $105 = $5.25. For the whole year, you would have earned an interest of $10.25. Hence,
you have actually earned a return of 10.25% on your $100. (even though the stated interest
rate is 10%). The reason for this is what we call the compounding effect. Midway through
the year, you got paid an interest, but you kept that interest in the bank. Hence, on your
next interest due date, the bank pays you interest on the original deposit, and also the
interest you kept.
Remember : the effective interest rate is the actual annual interest rate that accrues after
the effects of compounding (when compounding occurs more than once a year).
There is an easy way to calculate the effective interest rate without going through every
single step. This is the formula.
Let n = number of time the interest is paid a year.
Let i = your effective interest rate
Let apr = your quoted interest rate
(1+apr/n)n=1+i
i= [1+apr/n]n-1
So what has this got to do with your apr and your credit card debt?
Well, in the above example, you are lending the bank money. When you have credit card debt, your credit card issuer is lending you money. Unlike the first example, you do not pay your credit card company once a year.
You pay them every month. Most credit card issuers use a monthly periodic rate to apply to your
monthly balances. The monthly periodic rate would be the apr divided by 12. So if your apr is 10%, your effective rate is actually 10.47%. If your apr is currently 15%, you are really paying a 16.08% interest rate. If you are paying
a high 20% apr, the true effective interest rate is 21.94%.
The conclusion is that the quoted apr is not the true effective interest rate you are paying.
It is always higher because of the compounding effect. Whether it is your credit card or auto loan, unsecured personal loan, always ask your lender what is the effective interest rate. By now, you should know how to calculate
it yourself.
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