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Annual percentage rate (APR) is a number that represents the total cost of borrowing money from a lender. As you shop around for financing, it's important to understand how to calculate APRs and compare them between lenders and card issuers:
- The APR on credit cards is simply the interest rate the card issuer charges when you don't pay off your balance in full each month—it doesn't include the card's annual fees or other fees you may be charged for using your card.
- With installment loans, the APR incorporates the interest plus fees and other costs. The resulting rate helps you determine how much the loan will actually cost you each year.
How Is APR Calculated?
The way APR is calculated depends on whether you have a credit card or an installment loan. Here's how the two differ.
How Credit Card APRs Work
Credit card issuers typically base your APR on your creditworthiness (though some offer the same rate to all customers who get approved). This concept is called risk-based pricing—the APR you're approved for is based on how risky the card issuer considers you as a borrower.
Once your APR has been set, the credit card interest rate is applied to your balance only if you don't pay your bill in full every month. Credit card issuers calculate your daily interest rate by dividing your APR by 365.
For example, if your interest rate is 20%, your daily interest rate is 0.055%. So if you have a balance of $1,000 on day one of your statement, it'll become $1,000.55 at the end of the day with interest. If you don't make any new purchases on day two, your balance will increase to $1,001.10 due to daily compounding interest. As you make purchases throughout the month, your daily interest will continue to compound each day until the end of the statement period.
How Installment Loan APRs Work
A loan's interest rate is what the lender charges to allow you to borrow. Your creditworthiness helps a lender determine your interest rate. Interest isn't the only cost associated with borrowing, however.
For example, a mortgage APR may include points, which are fees paid to lenders at closing in exchange for a lower interest rate. Lender fees and other charges you may need to pay to secure the loan also count toward a loan APR. Some auto loan APRs factor in compensation for the dealership that's handling the financing.
Also, some personal loans carry an origination fee, which is deducted from your loan proceeds before you receive them. A loan APR takes these additional costs into account, which is why the APR is typically higher than your interest rate.
The actual APR calculation can vary depending on the type of loan and which costs are included in the rate.
APR vs. APY
It's important to note that an APR and an annual percentage yield (APY) are two different things. While an APR is used to show the cost of borrowing, an APY is used by banks and credit unions to represent the interest you earn on a deposit account.
Types of APR
There are several types of APR that can apply to credit cards and loans. Depending on your lender, you may come across a few different rates. Here's how each type of APR works:
- Purchase APR: This is the rate that applies to purchases you make with a credit card.
- Balance transfer APR: If you transfer a balance from one credit card to another, this is the APR you'll pay on that portion of your balance—it's usually the same as the purchase APR.
- Promotional or introductory APR: Some credit cards offer an introductory low or 0% APR on purchases or balance transfers to incentivize you to open an account.
- Cash advance APR: When you use your credit card to withdraw cash from an ATM, this APR will apply to the amount you withdraw. A cash advance APR is typically higher than the purchase APR and there's no grace period.
- Penalty APR: Many credit card agreements include a higher penalty APR that the company will charge if you fall behind on payments by 60 days or more.
- Fixed APR: This type of APR remains the same for the life of the loan. It's common among installment loans but rare with credit cards.
- Variable APR: This APR fluctuates along with market interest rates, which means it can increase over time. It's the most common type of APR for credit cards and is also an option on many installment loans.
What Impacts Your APR?
There are various factors that influence your APR, some of which you can control and others you can't:
- Credit history: Lenders may charge a higher APR if your credit history shows that you may be at a higher risk of default.
- Income: Your debt-to-income ratio (DTI), or the percentage of your gross monthly income that goes toward debt payments, is used by lenders to determine whether you can afford to take on more debt. A high DTI may result in a higher APR or denial of your application.
- Fees and other charges: If a lender charges fees on top of your interest rate, they may be included in the APR, causing it to increase.
- Prime rate: The prime rate is a benchmark that lenders use to determine their interest rates and is directly influenced by the Federal Reserve's federal funds rate. The prime rate can impact the rate you'll get when you apply for new loans, but it won't impact your open accounts unless the APR is variable.
- Loan type: Some loans naturally charge higher APRs than others. With a mortgage loan or auto loan, for instance, APRs are typically lower because you're using the home or car you're buying as collateral to secure the loan, which reduces the risk to the lender. In contrast, personal loans, credit cards and other unsecured loans typically charge higher APRs.
How to Avoid Paying Interest on a Credit Card
Credit cards are unique in that it's possible to take advantage of their benefits without ever paying a dime in interest. Here's how to maximize the value credit cards have to offer while avoiding interest charges:
- Pay on time and in full every month. Virtually all credit cards offer grace periods—typically 21 days or more after each monthly statement closes—during which you can pay your balance with no added interest. You can avoid paying interest entirely by paying off the full balance by the due date every month.
- Avoid cash advances. Credit card grace periods apply only to new purchases. Cash advances start accruing interest immediately, and at a higher rate to boot, so it's best to avoid them unless it's a real emergency and you don't have better options.
- Take advantage of introductory 0% APR promotions. Many cards offer introductory 0% APR periods on both balance transfers and new purchases, making it easy to pay down your debt interest-free. Just make sure to have a plan to pay off the debt before the promotional period ends.
- Avoid spending more than you can afford. It can be difficult to pay in full every month if you're spending without a budget. Create a budget and track your spending to ensure that you always stay within your means.
Improve Your Credit to Qualify for Lower Rates
Lenders consider more than just your credit score when determining your APR on a loan or a credit card. But the better your credit history looks, the higher your chances of scoring favorable terms.
As you work on improving your credit, it's no guarantee you'll get the best APRs possible, but it will give you the opportunity to get a lower rate than what you currently qualify for, which can save you a lot of money in the long run.