Credit cards and debt are a part of modern life. However, credit cards almost invariably have higher interest rates than any other form of debt a consumer is likely to encounter. Understanding a credit card's interest rate, and what the card's APR actually is, is therefore key to any sound money management plan.
A common misunderstanding with credit cards is that the Annual Percentage Rate (APR) is the actual interest charged on the outstanding balance of the account. This is not true. A credit card's APR is an estimate of what the interest rate is or will be in the near future. Given stable conditions, the APR is at best a partial reflection of the Effective Annual Rate (EAR), but this is not always the case. Unstable conditions can cause the APR to bear little resemblance to what the EAR will be by the end of a fiscal year.
The main differences between EAR and APR are twofold. First, EAR is not commonly recognized as a legal term, and certainly is not recognized as such in the states where nearly all credit card companies are based (such as Delaware). Second, EAR does not include one-time changes, such as front-end or late fees. It also does not include extraordinary circumstances, such as those that may cause your interest rate to change, such as late payment, balance transfers or special offers.
Credit card interest rates are determined mostly by the interest rate charged by the Federal Reserve, the issuer's projections on future inflation, and the issuer's evaluation of a customer's credit worthiness. Low interest rates, stable inflation, and good credit history can equal a low interest rate on a credit card. For example, many Americans enjoyed rates between 9 to 12 percent in the late 1990s, a reflection of the economic conditions of the time. The same Americans are now likely receiving rates of 15 to 19 percent on their credit cards, due largely to future projections for higher interest rates and greater inflation.
Credit card interest rates and minimum payments are often poorly understood, and this failure to understand them can result in substantial, crippling long-term debt. For example, assuming a stable balance and all other conditions remaining the same, an APR of 12.99 percent over the course of a year's worth of compound interest is the same as an EAR of 13.79 percent. The math involved in determining these figures is complicated. The result is that planning to pay down credit card debts by regular installments is often faulty, because in the case of a large balance, the difference of 1.5 percent can still add up to hundreds of dollars per year.
Credit cards offer consumers a ready source of credit. Despite the interest rates, which are always higher than those involved in bank loans, this can provide a useful tool for individuals or families seeking to make ends meet when faced with short-term financial difficulties. That is especially the case in the United States, where there's a very low rate of personal savings.