In the United States the Truth in Lending Act of 1968 requires creditors to disclose the interest rate in clear terms to the consumer. The familiar interest rate often advertised is the annual percentage rate or APR. For example, you may see an advertisement for a car loan with an interest rate of 7% APR. But, did you know that instead of paying 7%, you actually end up paying 7.23% interest? The reason is how APR is computed. By law, APR equals the interest rate per period times the number of periods per year. To convert APR to the effective annual rate (EAR), or what you will really pay, use the following equation:
EAR = [1 + (APR/12)]12 - 1
Or, from the example above:
EAR = 7.23% = .0723 = [1 + (.07/12)]12 - 1
You can also use the Excel function =EFFECT(rate, number_of_periods_per_year), for example =EFFECT(.07, 12) shows .0723 (or 7.23%) in Excel.
Even though the difference in the interest rate may seem small, this knowledge could save you some money each month, and more over the life of the loan. Plus, the higher the APR, the worse this deception gets. For example, that credit card at 18% APR comes out to an effective annual rate of 19.56%. So much for truth in lending. Something to think about the next time you're buying something on credit! (Sources: Wikipedia, Fundamentals of Corporate Finance, 8th Edition, Ross, Westerfield, Jordan, p. 168)