If you’ve got a credit card or a loan, you likely know that you’ll pay APR on your balance. But what does APR mean and how does it work? And what’s more, do you really understand how the APR will impact your finances?
“The details of your finances may not make for exciting reading, but understanding these important details is a crucial part of being able to manage your debt successfully, says Jeff Schwartz, executive director, Consolidated Credit Counseling Services of Canada.
“Understanding your APR (Annualized Percentage Rate) will let you more accurately understand the costs of taking out the debt at hand, as well as more effectively comparison shop between lenders and cards because you understand the true costs,” says Schwartz.
What does APR mean?
To break it down in simple terms, the APR (Annualized Percentage Rate) is the cost to you of borrowing when using your credit product. The APR reflects the yearly interest rate (i.e. what you’ll pay out over the course of a year in interest). You’ll find that this is often different between different cards and loans. Understanding the APR can help you do a more “apples to apples” type comparison so that you can choose the credit product that really costs the least.
It is this percentage that lets you calculate what your monthly costs are to carry that debt in terms of interest charges.
Why you need to read your statement
APR is variable, in that it fluctuates based on the bank’s prime rate. Realize too that there are often different types of APR attached to the same product. For instance, with a credit card, you’ll pay one APR for purchases and another for cash advances. Cash advances draw a higher interest rate and are calculated from the day you take them out, resulting in a higher APR.
Many lenders set a penalty APR as well if you should fall behind on payments. This is higher still. If you are struggling to make payments, this extra cost from falling behind can be problematic.
Another thing to be aware of is that lenders will often offer an “introductory” APR at a lower rate to entice you to sign up for their product. Once that APR expires, the balance remaining will be subject to the higher rate, which in some cases can make a substantial difference.
How do you calculate it?
To determine what your monthly interest rate costs are, you simply divide your APR by 12. Let’s say that your APR interest rate is 18 per cent. Your monthly rate than is 1.5 per cent (18 divided by 12).
To understand how this really impacts your balance, let’s say that you charge $1000 and don’t pay it off during that month. That $1000 is subject to a $15 interest charge. That doesn’t sound like much, right? But consider this:
If your minimum payment is 2 per cent, that’s going to be a $20 payment on that $1000. But as your APR demonstrates, you’ll have to pay out $15 of that $20 to cover interest charges. That means in this scenario, your minimum payment will only put $5 down towards actually reducing your debt load.
Why is this useful information?
To really pay down your debt, you need to attack the principal. When you’ve got a high interest bearing loan or credit card, the bulk of what you are paying out will go to service the interest, especially if you are only making minimum payments. As interest accumulates on your balance month-to-month, it can essentially take years to pay off your balance. Is it worth the cost?