Calculate Effective Interest Rate on Credit Card Loans

Calculating the interest rate on a credit card loan can be confusing because of the different interest rate terminologies and definitions.

APR

Let's take for example a loan of 10000 paid back over a one-year period with 1000 in interest added on so that at the end one ends up paying a total of 11000.

One way to compute the interest rate is to take that 1000 added on and divide by the loan amount so

1000/10000 = 10%

This interest calculation is commonly referred to as Annual Percentage Rate or APR. It is a simple calculation and, if you were to get the 10000 and then payback the loan at the end of the year as a lump sum of 11000, largely sufficient.  But for most amortized loans with a more involved payback schedule APR has the significant drawbacks of underestimating the true cost of the loan by not accounting for compounding and the time value of money.

IRR

In these cases a better computation of the cost is probably the internal rate of return or IRR.  IRR does not tend to get mentioned though perhaps because it is usually from the perspective of an investor or creditor. IRR is commonly defined as the rate at which the sum of the net present values of cash flows equals zero.  Computing IRR is better left to a financial calculator or computer since the manual computation often involves trial and error.  The accuracy of the computation is also reliant on the quality of the estimate for the discount rate applied to the net present value calculations.