Don't Be Fooled by APR

You've probably heard the term "APR" in car commercials on TV, but what exactly does APR mean? Well, APR is a sneaky way of making the interest you have to pay every year look smaller than it actually is. How does that happen? Well a lot of big companies want you to buy their products on credit, or take out loans from them, and since they benefit from the interest rate they charge looking smaller, they lobby government to be allowed to use APR in their advertisements. If you want to learn how to figure out how much actual interest you will pay, keep reading!

APR stands for "Annual Percentage Rate" but in reality, it is not the actual interestrate you pay each year, because it does not take into account how often the dealership will compound the interest. For example, an APR of 12% compounded monthly, means that you are charged 1% interest per month. Over the course of a year, that 1% is compounded, so by the end of the year you will have paid more than 12% interest.

Let's look at some numbers.

Let's say that on January 1^st you borrow $10,000, advertised at 12% APR compounded monthly. Each month, you will be charged 1% balance on your debt. So, at the end of January, you will be charged $100 of interest. Your outstanding debt is now $10,100. Therefore, at the end of February, you are charged 1% of $10,100, or $101. Your new outstanding balance will be $10,201. Each month, that 1% of interest will be charged on your growing debt. At the end of the year, instead of owing 12% of 10,000 in interest ($1,200) you will owe $1,269. The accumulated interest is actually 12.69% of 10,000. The 12.68% is your Effective Annual Interest or EAR.

How to Calculate the EAR

If you want to figure out the Effective Annual Rate for yourself, there is a fairly simple formula to remember. First, you need to know the APR and the frequency of compounding. Some loans may be compounded quarterly, monthly, or even daily. Monthly is common, so we will use that as an example.

First, we need to find a couple of numbers to plug into the equation. Take the APR and divide it by the number of months in a year (or quarters in a year, if interest is compounded quarterly.) That will give you your monthly interest rate.

The variables in the equation are:

i = monthly interest rate

m = number of months in a year

The equation is as follows:

EAR = [(1 +

i)^

m] - 1.

So, if we look at our earlier example of a 12% APR:

i = 12%/12 months = 1% per month

m = 12 months in a year

EAR = [(1 + .01)^12] - 1

EAR = 1.01^12 -1

EAR = 1.126825 - 1 = 0.1268