What is APR and what does it mean for your credit cards?
APR, which stands for Annual Percentage Rate, is the annual cost of borrowing money. If you borrow $ 1,000 for one year at 20% APR, the total payable would be $ 1,200.
Although this is a simple explanation, the APR can be a bit more complicated when it comes to credit cards. And despite how often the terms “APR” and “interest rate” are used interchangeably, they are not quite the same thing. To better understand what the APR is and how it determines credit card interest, here is a comprehensive introduction to the subject.
APR vs interest rate
The interest rate is a charge imposed by a lender for borrowing money. It is most often expressed as an annual percentage. An annual interest rate of 10% means that you pay 10% of the outstanding balance per year until it is paid off.
The APR is the total cost of borrowing money, and it is always expressed as an annual percentage. While it includes the interest rate, it also includes any other fees that the borrower has to pay.
Mortgages are an easy way to explain this because they have costs other than interest. A mortgage can include closing costs, private mortgage insurance, and application fees, to name a few potential extras. The mortgage APR includes these extras. This means that while a mortgage might have an interest rate of 4%, the mortgage APR could be 4.3%. Use our mortgage calculator to calculate your monthly payment.
However, with credit cards, the APR and the interest rate are interchangeable. Even if your card charges an annual fee, it’s not a cost associated with borrowing money. The only loan charges your credit card uses are interest, so the APR and the interest rate are the same thing.
How the credit card APR is determined
Credit card companies typically determine the APR using a few factors:
- Your credit history: A higher credit score can often help you qualify for a lower APR. For example, a particular credit card may offer APRs of 12.49%, 17.49%, and 21.49%, depending on the borrower’s credit.
- The prime rate: Most credit cards have a variable APR which depends on the US prime rate. This prime rate is based on the Federal Funds Rate, an interest rate controlled by the Federal Reserve. If the Federal Reserve raises or lowers interest rates, expect your credit card’s APR to change accordingly. Note that some credit cards have a fixed APR which remains the same regardless of the prime rate.
- Credit card: Like all other credit card features, the APR is also dependent on the card itself. Some credit cards have lower APRs than others. Rewards credit cards often have higher APRs because they offer more value.
Types of APR credit card
Credit cards can have several types of APRs. These may include:
- Purchase APR: The rate for purchases made with your credit card.
- APR balance transfer: The rate for the balances you transfer to your credit card.
- APR cash advance: The rate for credit card transactions classified as cash advances.
- Promotional APR: A temporary special rate, often 0%. Credit cards can offer a 0% introductory APR on purchases, a 0% introductory APR on balance transfers, or a 0% introductory APR on both types of transactions.
- APR penalty: A high APR imposed for violating your cardholder agreement. The most common reason for an APR penalty is a 60-day or more late payment on your credit card payment.
How the APR is used to calculate credit card interest
APR is a simple concept if the amount you owe stays the same day after day. It’s more complicated with the APR by credit card, because your credit card balance can change often.
To calculate credit card interest, credit card issuers typically use one of two methods:
- Daily balance: The card issuer divides your card’s APR by 365 to determine your daily rate. It multiplies your balance at the end of each day by this rate. At the end of each billing cycle, the card issuer adds up all of these daily interest charges to calculate your interest charges.
- Average daily balance: The card issuer divides your card’s APR by 365 to determine your daily rate. It multiplies that daily rate by the number of days in the billing cycle to determine your monthly rate. Finally, it multiplies your average credit card balance for each day of the month by your monthly interest rate to calculate your interest charges.
To find out which method your credit card company uses, check your card’s prices and terms. There should be a section called “How we are going to calculate your balance”. This section provides the method used by your card issuer to calculate credit card interest charges.
How to Avoid Credit Card Interest
Credit card APRs are generally high – much higher than what you would find with a mortgage APR or an auto loan APR. For this reason, the smartest option is to avoid credit card interest altogether.
Fortunately, there is an easy way to do this. Use your credit card only for purchases and pay the statement balance in full each time you make your monthly payment. Credit card companies don’t immediately charge you interest on purchases. They charge interest on your statement balance if you don’t pay everything by the due date.
Keep in mind that this only applies to purchases. For other types of transactions, such as cash advances, the card issuer may start charging you interest immediately.
Another way to avoid interest charges on your credit card balance is to take advantage of introductory 0% APR promotional offers. If you have any purchases that you won’t be able to pay in full, open a card with an introductory APR offer of 0% on purchases. If you have credit card debt that costs you money every month, look for a balance transfer card with an introductory 0% APR on the balances you bring.