What is APR?

Here's What It Is

It's an interest rate annualized over one year. That explains the acronym "APR" which stands for Annual Percentage Rate. What really matters is how it's annualized. Specifically how the annual percentage rate can be less than the effective annual rate.

1) APR is annualized by multiplying the period rate by the # of periods in the year

2) EAR is annualized by raising the period rate to the power of the # of periods in a year.

Here's Why it Matters

In this example, we observe that given the same one-month interest rate of 1%, the way we annualize it makes one look smaller and one look larger. The rates are the exact same in reality, 1% a month is 1% a month no matter how you chop it.

No surprise to anybody, advertisers seem to love APR. In this case, the difference was.63%. That might not seem like much but it's a long way from zero. Want to decrease the number of periods in a year? The difference only gets larger.

What do I do with this information?

The lesson here is pretty simple, do not compare APR to APR and assume it is apples to apples. Always remember to look at the assumptions that go into the APR advertised. Here is a good example:

1) Interest rate of 12% annually

2) APR of 12% based on a one-month period rate ( and a $5 gift card!)

The average person would probably think " well, I guess I'll go with two because the rate is the same and I get a gift card". As a matter of fact, the person who chooses two has cost themself .63% annually. Unless you're taking out a loan to buy a pack of chewing gum, that .63% matters.