Understanding APR and Balance

This is one of the best articles I found on Internet to understand APR.
(Source :- http://www.careonecredit.com/Knowledge/cost-of-credit.aspx )

The Cost of Credit: Understanding APR and Balance Calculations
The cost of credit is not as easy as simply knowing the interest rate. Learn how to evaluate the APR to make good credit decisions.
The Annual Percentage Rate (APR) is the cost of credit (actual interest rate) expressed as a yearly rate. Comparing the APR of loans or credit cards is a quick way to determine which loan or card will likely cost you the most, excluding optional fees such as late payment fees, ATM fees, or obtaining a cash advance. Whether your interest is calculated daily, monthly, or yearly, the APR provides a standardized way of comparing the interest rates on different cards or loans.
The federal Truth in Lending Act requires creditors to disclose the APR on your loan transactions. Why do you need to understand this information? As a consumer of credit, you benefit from understanding the commitments you are making with your money and with your reputation in the credit marketplace. You will also be in a better position to choose the appropriate credit card for your needs. For an example of interest rate and fee disclosure, see the Bank of America terms for one of its credit cards.
Calculating the APR
On credit card billing statements, the finance charge (interest) is expressed in two ways, as a periodic rate (monthly or daily) and as the annual percentage rate. The monthly periodic rate is the annual percentage rate divided by 12.

The example below shows how the APR affects the cost of credit.
To determine the monthly periodic rate on a yearly APR of 18%:
18% ÷ 12 months = 1.5%
To calculate the finance charge using a monthly periodic rate, multiply:

Average Daily Balance x Monthly Periodic Rate = Monthly Finance Charge
(For this example, $100 is the account balance)
$100 x 1.5% = $1.50

Some cards use a daily periodic rate to calculate the finance charge. To get the daily periodic rate, you divide the APR by the number of days in the year (365).
To determine the daily periodic rate on a yearly APR of 18%:
18% ÷ 365 days = .05%

To calculate the finance charge using a daily periodic rate, multiply:
Average Daily Balance x Daily Periodic Rate x Days in the Cycle = Monthly Finance Charge
(For this example, $100 is the account balance)
$100 x .03288% x 31 = $1.02


Balance Computation
Although looking at the APR is the most obvious way to compare credit cards, the method by which credit card issuers determine your balance can make a big difference in how much interest you pay. Here are some of the ways a creditor can calculate the finance charge on your credit card or loan:
Average Daily Balance – The balance is calculated for every day in the billing cycle. Each day, new charges or payments are added to or subtracted from the existing balance. All daily balances are added together and divided by the number of days in the billing cycle to get the average daily balance. The average daily balance is multiplied by the periodic rate to get the finance charge. This is the most common form of balance computation used by credit card issuers.
Two-Cycle Average Daily Balance – The balance used to calculate finance charges is based on two billing cycles. The average daily balance for the current billing cycle and the average daily balance for the previous billing cycle are each calculated as described above. The finance charge would be the sum of both average daily balances multiplied by the monthly periodic rate. Usually this is the most expensive form of balance computation for the credit consumer.
Adjusted Balance – Additional purchases made during the current billing period are not added to the balance for purposes of calculating the finance charge. The payments and credits for the current billing cycle are subtracted from the balance as it was at the opening of the billing cycle, and the finance charge is calculated using this number. Since new purchases are not included (which would raise the balance) and payments are included (which lowers the balance), it usually means a less expensive finance charge. Of all the balance computation methods, it is the least costly to the borrower.
Previous Balance – The previous balance method of computation uses the balance at the opening of the billing cycle. The payments received during the current billing cycle are not subtracted from the balance and additional charges are not added to the balance. The previous balance method results in more costly finance charges than the adjusted balance method because current payments (which would lower the loan balance and thus the finance charge) are not included in the calculation. On the other hand, using the previous balance method results in lower finance charges than either of the average daily balance methods of calculating interest owed.
Shopping for a Low APR
Selecting a credit card with a low APR is good, but you should compare other things as well.
One card may have different APRs for each feature of the card. For example, purchases may be subject to an APR of 14%, while cash advances obtained with the same card may have an APR of 17%.
If your credit card has a variable rate, it can change throughout the year. Read your disclosure statement or talk to your lender to find out additional details about your annual percentage rate.
Look for a card with an APR that suits your situation. If you can pay your balance in full every month, having the lowest APR is not as important as the other fees associated with the card, such as annual fees or cash advance fees. However, if you carry a balance from month to month, then you want the lowest APR possible. But analyze carefully the terms for credit cards with lower APRs. Lenders frequently try to balance the low interest rates with high annual fees and penalties. To compare credit card interest rates and fees, visit the Bankrate.com and the IndexCreditCards.com websites.
Time vs. APR
If you have a credit card with a high APR, you can minimize the effects of this by paying off the debt in a shorter time period. You do this by paying more each month on your credit card balance. This results in a rapidly declining balance that greatly reduces the finance charges. The examples below compare the total finance charges of cards having two different APRs (14% and 18%) with two scenarios (paying the minimum or paying significantly more).
Example 1: There is a 14% APR. The credit card balance is $1,000. We'll assume that no additional charges will be made until the current balance is paid in full. Monthly payments will be received by the due date. If you make a minimum monthly payment of $30, it will take more than 3 years (43 months) to repay the debt, and the total interest paid will be $273.74. But if you choose to make a higher monthly payment of $100, it will take less than a year (11 months) to pay off the balance, and the total interest paid will be $69.50
Example 2: There is an 18% APR. The credit card balance is $1,000. No additional charges will be made until the current balance is paid in full. Monthly payments will be received by the due date. If you make a minimum monthly payment of $30, it will take 4 years (47 months) to repay the debt, and the total interest paid will be $369.74. But if you choose to make a higher monthly payment of $100, it will take 11 months (the same amount of time as it would take to pay off the same debt carrying the 14% APR), and the total interest paid will be $91.57.
These examples show that making a monthly payment greater than the minimum diminishes the impact of the higher APR. In the two examples, paying a higher monthly amount results in paying only $22 more in finance charges if you have the more expensive APR.
Be aware that credit card balances can increase rapidly when only the minimum payments are made and balances are left to accrue interest over time. If possible, only use your credit cards when necessary and pay more than your minimum payment amount each month. Credit grantors are in the business of making money off of your credit card habits, but remember that you can sometimes negotiate with your issuer to obtain a lower APR or lower fees.
It's Not Only APR
In short, the APR is a convenient way to do your first comparison of credit cards, but you must look carefully at other factors, such as the method the creditor uses to calculate the balance used to determine finance charges, and the other fees and penalties associated with the card. Above all, you can save yourself the most money by making the highest monthly payment you can afford to eliminate the debt as quickly as possible.
This article is one in a series about credit cards. For help in selecting a credit card, read the U.S. Federal Reserve article Choosing a Credit Card. For further information on credit, read the related articles in our Knowledge Center Library.
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