Whether buying a house or using a credit card, APR (annual percentage rate) drives the cost of any financed purchased.  Borrowing money smartly can be used to create leverage and build wealth, however, using credit poorly reduces wealth and creates poverty.

First what is APR?

APR as defined by Investopedia:

DEFINITION of ‘Annual Percentage Rate – APR‘ The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.

In simple terms, APR is simply the cost of borrowing money, but beware as something so simple is often much more complex.

APR and Credit Cards

Unfortunately credit cards are the life blood of many Americans and cause a lot of heartache and never ending debit payments.  The reason credit cards are so attractive is that they give many people instant purchasing power instead of saving and waiting.  But instant gratification comes with a price.

How many of you would buy something if I told you the following:  Here is a great deal on this new pair of shoes, regularly $150, but today they are only $75 if you buy on our credit card with low monthly payments.  After you pay them off your total price will be $185, what a great deal!

Sounds silly, but that is what millions of us do every day (myself included).

So, if we are going to use credit cards then at least you should know what you are paying and how they work.

1. APR
   

   This is the rate you will pay on your purchases. To get a rough idea of how much this will cost simply take your purchase multiplied by the interest rate and divide by 12.  This will give you an approximate monthly interest amount (it is more complex but this give you a rough idea).

For Example: if you carry $5,000 on a credit card with 28% interest, you roughly pay (5,000 *.28)/12 = $116 per month in interest.  Wow that is more than the cost of a cell phone plan with full data and unlimited voice minutes.

2. Interest Calculation and Daily Periodic Rate

In point 1 above, there was a simple way to calculate a rough idea of what you interest would look like on a month to month basis.  In reality, it is much more difficult and depends on the way the credit card does their calculation.

Most credit cards use a daily interest rate plus an average daily balance.  The math behind this gets a bit more complicated, but the idea is to take the interest rate and divide that by 365.  To make things worse, some banks use 360.  Either way, the resulting number is the daily periodic rate.

The next part of the formula is called your daily balance.  This will take the daily balance for each day and average out the amount to arrive to your daily balance.  Keep in mind if you pay something in the beginning of the month, it has a lot larger impact than the same amount paid at the end of the month.

Now that you have your daily periodic interest rate and your daily average balance you can calculate your interest rate amount.  This is done by multiplying your average daily balance by your periodic rate multiplied by the days of months in that month.

Pretty confusing and not to practical for anyone but the banks to do.  The other thing this method does is that it compounds interest amounts in your daily balance meaning that you actually pay more interest on your balances than the stated APR.  It is not lying, it is all in the way the numbers work.

3. Low minimum monthly payment
   This one is important as it is where most people don’t understand how credit cards work and why you can end up paying more than 5 times the cost of your purchases.

Your monthly payment is calculated by the interest payment plus some small percentage of the balance (usually around 4%).  Sounds simple right?  This is where you get the taken by the credit card companies as they play on your emotions by keeping your monthly payment low.

Let’s continue with our example of $5,000.  Your payment would be calculated based on the 28% interest rate plus 4% of the balance divided by 12 (calculated each month).  In this case your payment would be around $200 (if fixed) and take you 16 years to pay off.  Yup, 16 years, costing you $11,669.

Here is what is even worse, as you slowly work down the balance, your payments go down which extends the 16 years to an even longer period.

Basically the whole system is designed to let you never pay off the balances and that is exactly what happens to millions of Americans each year.

4. Other Fees

Credit cards also take on yearly, monthly, or other fees which contribute to the $11,669 you will pay for your $5,000 of value.

5. Variable APR and Variable interest rates

Just to make sure you don’t have a clear understanding of your costs, credit card companies create Variable APR (exp: prime +10 or 15% + 10 Yield) or add variable interest rate deals (fixed at 1.9% for one year).

Any of the Variable APR or Variable interest rates can be extremely complex or hard to remember what you have.  That is what they count on.

6. Default APR

Again, another place the credit card companies make it impossible for you to get the best value.  Your default APR is simply the rate that is used if you default any terms in your agreement.  One late payment, $1 over the limit, etc.

Very few lending facilities have default APR, instead they use late fees or other methods.  Credit card companies use them all.  If you are late one time, you interest rate goes up, you pay a late fee, and probably waive the yearly discount on the card you got when you signed up.

Your only recourse is to pay off the balance or call them to see if they will lower your fees.  Sometimes they do and it is worth the call, but often they don’t.  Unless you have the cash, you are now stuck at even worse terms and deeper into debit.

7. Lastly, They Can Change Whenever They Like

That is right, they simply mail you a notice and change your terms.  If you don’t like them you can pay off the balance or close the card.  Does not seem to fair, because it is not.

These letters can add fees, change APR rates, increase late fees, take away benefits, etc.

Hopefully you can see that everything is against you when you use credit cards.  Unless you have a really good reason, you should never use them.  Some people pay them off monthly to get rewards and points, that is ok and a good use if you are disciplined.

Remember, you are paying a hefty price for the privilege of using a credit card, but more importantly you are committing future hard earnings to pay the bank.