02 August 2011

Lesson 2: APR - The Real Cost of Credit Card Annual Interest Rate

Read the basic difference between APR and AER before continue reading the below.

Refer to the annual interest charges for Maybank credit cards.

Assume you are one of those who constantly spend more than you earn and frequently misses your payment, putting yourself in Tier 3 bracket of 17.5%.

Say, you have outstanding balance of RM 10,000, so you'll think (I did previously) that, even if I don't pay a single cent for the next 12 months, by the 13-th month, I would need to pay 117.5% x 10,000 = RM 11,750. Or, you think, every month, I will be charged a monthly interest of 17.5% /12 = 1.4583%

Not quite that simple. Confused? Let's solidify the concept with an example below.

Remember, you get your credit card statement monthly - your outstanding balance plus interest incurred previously will be carried forward to the subsequent month. That means, the compounding period is monthly!

In other words, as you are well aware, for the first month, the outstanding balance plus interest incurred is RM 10,145.83. On the second month, the 1.4583% interest will be charged on RM 10,145.83 brought forward from the first month. See the impact of compounding over here?

Effectively, once you want to settle the balance outstanding after the 12th month, you will be paying MORE than the advertised interest rate of  17.5% due to compounding, because 17.5% is really the APR!

The actual interest rate you will be paying is the AER. For APR of 17.5%, the AER is 18.974%!! See APR to AER conversion here.  Or in monetary amount, RM 11,897.40 instead of RM 11,750.00

Still don't believe me? Read this and compute FV in excel with the following inputs: nper = 12 months, 0.014583 for rate and PV = -10,000. Put zero for Pmt. The concept is similar.

So, why banks quoted you 17.5%?

Simple, because it is a lower number between the two. When you are the bank's debtor, bank need you give you the disguised impression that you need pay less than you are actually paying. This is marketing - they are not actually lying to you, just that it's not the whole truth. You have nothing to blame but your own ignorance. Different countries have different rules and regulations in place to combat some of the unscrupulous activity surrounding quoting rates that has arisen in the past; however, there is no better insulator against these ruses than proper financial knowledge. If you know of any bank which quote AER instead of APR for credit card interests, let me know - I am pretty sure their credit cards product would not be selling too well even though they are telling the truth to customers!

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