Do you know what APR is?

Let's look at a fictitious story. You have a friend who isn't very financially savvy. She comes to you and says, "I've always heard that I should shop for the lowest APR but what is APR?" How would you answer her? If you're like many people, including some of those claiming to know something amount finance, you don't know about APR and would not be able to help your friend.

APR, or annual percentage rate, is the amount of interest you would pay per year on a purchase. With that, it would make sense that if you made a $50 purchase and your credit card had an APR of 10%, that means that if you didn't pay this expense off within a year of purchase, you would pay $5 in interest for a grand total of $55 for the year.

In the world of finance, rarely is it that simple. The fact is that different credit card companies calculate interest differently. Most calculate by compounding interest. This means that each month the interest that added up that month will be added to the principal (the original purchase) and the following month, the principal plus the interest is used to calculate the monthly interest added. Our $50 purchase becomes $55.24 rather than $55.

Doesn't seem like a big deal does it? 24 cents isn't anything to get upset about but who holds on to a $50 credit card balance for a whole year? What if you have a $10,000 balance? The 10% APR would make your purchase $11,000 but if calculated by compounding, you will pay an extra $47.13 on top of that $1,000 in interest!

We also have to know the difference between variable and fixed interest rates. Some credit cards will tell you that their interest rate is fixed. This means that they have to give you notice before changing your interest rate. Variable interest means that your rate will constantly change depending on the prime rate. The prime rate is the lowest interest rate that is being given to preferred borrowers. Many variable interest rate credit cards charge prime rate plus 3%. You can find the prime rate in the newspaper or many other business websites.

How does it feel to know that your $1,000 purchase would cost you $147 per year if you don't pay off the card? What could you do with that extra $147? If you were to save your money over the course of a few months and make your $1,000 purchase in cash, not only will you save the $147, put you could use a rewards card for your purchases plus put that $147 in to a savings account. While credit cards are as American as baseball, think of all of the ways you could use that $147.

The easiest way to understand APR is to pay your balance in full each month. If you don't have a balance after your bill is due, you don't pay any interest so APR, compounding, and the many other financial buzz words don't have to be understood.

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