Annual Percentage Rates (APR) and Your Credit
Whether you’re a first-timer or seasoned user of credit, it’s important to understand all the credit-related terms you may encounter. Knowing how credit works can help you make more informed decisions about how to use it. One term you’ll encounter with virtually any type of credit is APR—annual percentage rate.
What Is an APR?
Whether it’s a credit card, auto loan, mortgage or other types of credit, every form of credit comes with costs, including interest (the money the lender charges for allowing you to use their funds) and fees. APR incorporates all those costs into a single, understandable rate to help you better understand how much the loan or credit card will actually cost you in a year.
The terms, fees and interest rates of different credit agreements can vary, so APR uses a standardized computation to give you a bottom-line number that can help you compare lenders and deals. Generally, a lower APR means it will cost less for you to borrow money, and your monthly payments will be lower.
Credit Card APRs
Credit cards can have more than one type of APR, and the different types of credit card APRs are tied to what you do with the card. When you look at your credit card agreement, you may see language about these types of APR:
- Introductory APR — Credit cards and retail cards will often offer a low or zero APR in order to give you an incentive to apply for a credit card. This promotional low rate is available for a set amount of time—at least six months but sometimes as much as 18 or 24. When the introductory period ends, the APR will increase and so will the cost of using the credit card. Your APR may also increase if you violate any of the terms of the credit card agreement, such as failing to pay on time or paying less than the minimum monthly payment amount.
- Balance transfer APR — If you move a balance from one card to another, you’ll be charged a balance transfer fee, which could be 3% or more of the balance amount transferred. The balance transfer APR would apply only to the transferred amount, and not to new purchases, which would have a separate purchase APR. Information about rates can be found in the “Schumer Box” which is a summary listing the various interest rates and fees associated with a credit card.
- Purchase APR — This is the annual percentage rate that applies to purchases you make with the card. If you use your credit card to make a purchase and pay off the full balance in the next month, you can avoid paying interest on the purchase and avoid paying interest.
- Cash advance APR — When you use your credit card to withdraw cash from an ATM, this APR will apply to the amount you withdraw. Typically, cash advance rates are higher than purchase rates. As soon as you take the cash advance, you will begin paying interest on the amount.
- Penalty APR — Most credit card agreements include a penalty APR that the company will charge if you fall behind on payments by 60 days or more. All the balances on your account will be subject to the penalty rate, which is often much higher than other interest rates. The average penalty APR is about 30%.
Calculating Credit Card Interest
When you carry a balance on your credit card, interest accrues. Different credit card companies employ slightly different formulas using a daily or monthly periodic rate to calculate how much interest you pay.
- The average daily balance method — The credit card issuer adds up your balance for every day in the billing cycle and then divides that figure by the number of days in the billing cycle. For example, $1,000 divided by 25 days equals an average daily balance of $40. That average daily balance is then multiplied by the daily rate, which is your APR divided by 365 or 360. So if your APR is 20%, your average daily rate would be 0.20 divided by 365 and multiplied by 100, or 0.054. To calculate your interest charge for the month, you would multiply $40 by 0.054 resulting in $2.19.
- The daily balance method — Rather than averaging your daily balance, the credit card issuer multiplies your balance each day to arrive at a daily finance charge, and the charge for each day of the month gets added together to equal the finance charge for the billing cycle.
It’s important to remember that interest compounds; the finance charge adds to the balance you owe, so your balance can grow during the month or from month to month, even if you don’t make any new charges.
APRs for Loans
APRs for loans such as mortgages and vehicle loans encompass more than just the interest rate. Remember, the interest rate is the money the lender charges to allow you to use their funds. However, it’s not the only cost of borrowing money.
For example, mortgages also come with points, broker fees and other charges you will need to pay in order to secure the loan. APRs for dealer-underwritten auto loans usually include compensation for the dealer handling the financing. The APR takes these additional costs into account, which is why it’s typically higher than your interest rate.
However, the interest rate is still a very important number when you use credit. Depending on the type of loan you get, the interest rate can even change over the life of the loan. This is common with home loans, which can either be fixed-rate mortgages—the interest rate remains the same over the life of the loan—or adjustable-rate mortgages, in which a lower initial interest rate resets to a higher rate after a specified number of months or years.
A Final Word About APR
APRs are intended to help make it easier for borrowers to compare loan and credit card offers, and to understand the full costs of the money they’re borrowing. Because APR takes into account all the costs associated with a credit card or loan, it’s a better indicator of just how much a type of credit will cost the borrower.
Generally, a lower APR means a better deal, but it’s also important to read the full loan or credit card agreement to be sure you understand all the costs, terms and conditions of the credit issuer.