Difference between APR and effective APR

We've got our sights set on the plastic in your wallet. You'll likely find lower credit limits, higher interest rates, and higher fees than what many have been accustomed to in recent years. But don't jump at those new credit card offer just yet!

President Obama had called on congress to pass credit card reform legislation by Memorial Day. The Senate on Tuesday voted almost unanimously in favor of credit card reform. The bill, expected to be taken up by the house later today, would make it tougher for credit card issuers to raise fees and interest rates starting early next year.  But you might be paying more than you think for your credit card.

We all know the term APR - annual percentage rate - but the number consumers should really be paying attention to is "effective APR."

“An effective APR represents your total cost of credit," explains Greg McBride, a senior financial analyst at bank-rate.com.

"Keep in mind, this may be more than just the interest rate. If you're paying an annual fee, if you incurred a balance transfer fee when transferring the balance to that card… those are costs that will add to the interest rate that you're effectively paying, effectively raising the cost that you pay on that balance.,” says McBride.

Your own effective APR is unique –different from everybody else's. Here's an example of how to calculate your effectiveAPR from Bill Hardekopf at low-cards.com.

Our hypothetical guy - let's call him Tony - applied for a credit card with zero percent APR for one year. He spent $1,000 on the card and decided to make only the minimum payments for that first year.

Later, he took out a $2,000 cash advance - not realizing there was a  fee for that - and that cash advances come with  a much higher interest rate than purchases. Then, Tony missed a couple payments, which triggered two late fee charges. It also triggered a default rate.  And his card rate was raised to 29.9 percent.

He eventually paid off the entire card and closed the account. So this guy ‘Tony’ was tempted by the zero percent introductory offer, but it cost him dearly. Let's add up the total costs to the card:

$75 interest on purchases
+ $379 interest on cash advances
+ $60 cash advance fee
+ $78 late charge fees
So he's spending $592 on all these extra costs... Which makes his effective APR 19.7 percent.

On a card that was supposed to be zero percent APR! So what should consumers be aware of when they're looking to open a new credit card?

Introductory rates, payment schedule, cash advance fees, late fees, and default rates. Those are numbers not even in the fine print, but in the regular print. You really have to sit down and crunch those numbers to determine what is the best card for you.

As we just explained, effective APR doesn't necessarily jive with the APR printed on the credit card offer. And remember, some of these expenses are easily managed. Make your payments on time, keep and eye on your rate schedule, and avoid cash advances whenever possible.

Posted by: Gerri Willis: CNN Personal Finance Editor
Filed under: Finance • Living • Willis