Understanding the Annual Percentage Rate (APR)

The annual percentage rate can seem like calculus to most people. It's some arcane and hard to understand method to help credit card companies know how much money to charge you every month for interest. The problem is—that makes the annual percentage rate, or APR, very important if you use your credit card. So it's just as important for you to have some understanding, even if just basic, of how the annual percentage rate is calculated.

First, you should get the definition of the annual percentage rate. It's actually pretty simple if you look at the APR from this way. By definition, the annual percentage rate is the yearly rate of interest that the credit card charges you, including any fees and costs paid to acquire that loan. The credit card companies figure out this loan in a pretty straightforward way, believe it or not. They take the average compound interest rate of the term of your loan. That way, you can compare one credit card debt, or loan, to another.

The annual percentage rate for a credit card company, in this respect, is just the same as the annual percentage rate that you'd be paying for a mortgage, for instance. But with a mortgage, the details are different. For instance, with a mortgage, the APR includes the interest rate of a mortgage taking into mind not only the interest, but the mortgage insurance, and certain closing costs and even points paid at the time of closing.

Credit card companies, like mortgage companies and other lenders, are required by law to always let you know what your annual percentage rate is. That way, when you're shopping for credit cards, you can compare them by the annual percentage rates. If you plan to carry debt on your card, or roll it over from one card to the next, you can then know basically how much you could save month to month, credit card to credit card.

With credit cards, of course, there are even more things to consider when comparing one to another. Besides the annual percentage rate, you should look at a card's payment schedule—how much grace period do they give you to pay off a purchase, and what's the penalty if you fail to make a payment on time, or miss one altogether? Also, you should look at each card's rewards programs. What is the ratio between purchases and reward points, or cash back? Is it 1 point for $1? Do you get 1 percent cash back, or 5 percent? All of these factors, as well as annual percentage rate, should be taken into account.