If you read one of our other articles, then you know all about annual percentage rates (APR). In short, an APR defines what indebted consumers pay each month in interest accounting for lender expenses and the market rate. The debt includes consumer credit, student loans, mortgages, and more.
It seems obvious that APR is a pretty important part of borrowing money. Despite this, many people do not understand how APR is calculated when you have outstanding debt. To understand this, you need to understand compounding interest first, so read up on that pronto!
If you just caught up or if you already know what compounding interest entails, then we’ll get back to it. So, how does your APR determine your interest rate? Let’s find out.
For starters, an APR can be compounded in multiple different ways. The most common ways are daily and monthly. It can even be compounded yearly, but that’s not so common for the common debtor. On debt such as student debt and credit cards, you’ll want to understand monthly and daily compounding, respectively.
Let’s start with monthly. An APR that is compounded monthly can be dubbed the monthly periodic rate. To find this value, you just divide your APR by the number of months in a year (12!). At the end of the month, the interest payment is defined by the monthly periodic rate which taken is multiplied by the outstanding balance at the time of the charge.
An example illustrates the concept perfectly. You have a 12 percent APR that is compounded monthly and a current balance of $1,000 in student loan debt. At the end of the month, you will owe $10 in interest for a grand new total of $1010 on your account. If you let that alone for another month, then your new account would be $1020.10 (compounding effect!).
Let’s get to daily. An APR that is compounded daily is known as the daily periodic rate, and you can expect to deal with this on credit card debt. Similar to the monthly rate, you just divide the APR by the number of days in a year (365!). At the end of the billing cycle, the interest payment is defined by the compounding effect of the daily periodic rate.
Another example works here. You have an APR of 12 percent that’s compounded daily, so your daily periodic rate is 0.0329 (rounded up). After a 30-day and a half billing cycle with a $1,000 balance, you would owe a new total of $1,010.05. Voila! That’s how you credit card interest is calculated.
Just so you know. The whole point of a daily periodic rate versus a monthly rate is to make more money. If you take the $1,000 scenario using a monthly rate, then you would have owed $1010 at the end of the month like in the student loan example. The difference is minuscule for $1,000, but lenders are making a lot more cash when they do this with billions of dollars.