Stories of people who are thousands of dollars in debt are all pretty common.
But in most cases, it wasn’t the debt alone that did them in.
Each time they didn’t pay their balance in full, they were charged interest. Over time, those interest charges add up.
There’s Tanya LaPrad, who faced $358 monthly interest charges on $20,000 of credit card debt before she started a debt management plan.
And Joe Mihalic, who took out $95,000 in student loans to go to Harvard Business School and realized he’d be paying $42,000 in interest before paying off his debt if he stuck to the minimum payment schedule.
The moral of all these stories? Read the fine print.
If you’ve borrowed money, you’ve probably seen the acronym APR. But what does it mean and how can it hurt you?
What is APR?
APR stands for annual percentage rate. In other words: The percentage you’ll pay in a year to borrow money.
“Think about it this way — when you buy any kind of service, you have to pay something for it,” said Kathryn Hauer, a financial planner and investment advisor in South Carolina.
“Borrowing money is a kind of service, and you have to pay some amount for that service.”
Hauer explained that APR includes the actual cost for borrowing the money (the interest rate), plus other items, like late penalties and transaction fees.
There are two types of APR: nominal and effective.
Typically, what you see advertised for most loans is the nominal APR. It’s a good metric for comparing loans, because it includes both interest and fees.
When you compare two loans, look at how each one’s APR compares to its interest rate. This will tell you which loan comes with higher fees.
Here’s a quick breakdown:
Nominal APR is the simple rate of borrowing money for a year. If you borrow $1,000 with a 20% rate, you’ll pay $200 to borrow the money for a year.
Here’s the formula: $1,000 x 0.20 = $200.
Effective APR, also known as the effective annual rate (EAR) or the annual percentage yield (APY), takes the power of compounding into account. In this case, the lender charges interest on the interest they’ve already charged you.
To calculate the effective annual rate (EAR), use this formula: EAR = (1 + r/m)m – 1, where r is the interest rate as a decimal figure and m is the number of compounding periods.
In this case, (1 + 0.20/12)12 – 1 = 0.2194, or 21.94%. Now, the $1,000 you’re borrowing for a year, compounded monthly, will cost you $219.40 to borrow.
The $20 difference in this example may not look like much, but what if you’re borrowing $10,000? Or $30,000?
Confusing, right? Don’t worry about the math. Do it if you can, but make sure you ask your lender how interest is calculated. Is it compounded? If so, how often?
What Determines Your APR?
Lenders use your credit score to determine a loan’s APR, and it’s based on your past credit history, as well as other factors.
“Sometimes people have no choice but to pay a high APR because they have a poor credit record and the lender is worried about the borrower not being able to repay the loan,” said Oviedo, Florida, financial planner David Blount.
“When lenders consider borrowers as ‘high risk,’ they charge more for lending the money in case it is never paid back.”
In some instances, you can actually negotiate your way to a lower APR. The financial planners over at LearnVest even have a nifty script for calling your credit company and negotiating your way to a lower APR.
Some lenders charge a fixed APR, meaning it stays the same for the entire life of the loan, while others charge a variable APR. These rates can go up and down based on an underlying index, like the U.S. Prime Rate.
Blount also pointed out lenders may have multiple APRs for a loan you’re interested in. They may offer a low introductory rate to get your business, but after a certain period of time, the APR may go up.
Credit card companies also may offer differing APRs for different types of services and transactions, such as cash advances or transfers.
The Bottom Line
You may be the type of person who pays off your credit bill in full every month. And you should, if you can.
But you could be one step away from not being able to pay off the full balance. Say you lose your job and have a hard time finding another one.
You’re going to start paying interest.
Comparing APRs will help you make smarter choices when selecting a credit card or a loan. Get the lowest rate you can, even if you think you’ll make regular payments.
“You’ll be a more confident and value-conscious shopper if you are able to understand the workings of the APR,” Hauer said.
“When you compare rates for getting your hair colored, repairing your car, or taking guided kayak tour, you make sure you know the exact cost, including any extra fees. When you look into the best place to borrow money, you can use the APR to compare and make the right decision.”
Better yet, if you don’t have to borrow money, don’t.
“Saving up for your purchase and paying cash is one of the best alternatives to getting caught up in the death spiral of too much debt,” Blount said.
Your Turn: Have you ever tried to negotiate a lower APR?
Sarah Kuta is an education reporter in Boulder, Colorado, with a penchant for weekend thrifting, furniture refurbishment and good deals. Find her on Twitter: @sarahkuta.