What Is APR and How Does It Affect Me?

What Is APR and How Does It Affect Me? article image.

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Annual percentage rate, APR for short, is a number that represents the total cost of borrowing money from a lender.

With installment loans, the APR incorporates the interest the bank, credit union or finance company charges, plus fees and other costs. The resulting rate helps you determine how much the loan will actually cost you each year.

The APR on credit cards, however, is simply the interest rate you'd pay when you don't pay off your balance in full each month and leaves out any other charges, such as a card's annual fee.

As you shop around for financing, it's important to understand how to calculate APRs and compare them between lenders and card issuers.

How Is APR Calculated for Credit Cards?

Credit cards can have more than one type of APR, and the different rates are tied to what you do with the card. Before we get into the details of each type of APR, let's go over how credit card companies calculates an APR in the first place.

How Your Credit Card APR and Interest Charges Are Determined

Credit card issuers sometimes offer one APR for everyone who gets approved for a credit card, but most of the time, they provide a range instead. The APR you qualify for is based on your creditworthiness. You can check your credit report with Experian as well as other credit bureaus.

This concept is called risk-based pricing—the APR you qualify for is based on how risky the card issuer considers you to be. If you have excellent credit and a strong financial profile, for instance, you may qualify for the card's lowest interest rate. But if your credit score is low among qualified borrowers, your APR may end up on the higher end of the spectrum.

Once you know the APR, you can break it down to understand how much interest you'll pay on a monthly basis. At the end of each day, your credit card issuer will calculate your daily interest rate by dividing your APR by 365.

For example, if your interest rate is 20%, your daily interest rate is 0.05479%. So if you have a balance of $1,000 on the first day 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 statement closes.

Of course, that doesn't mean you'll actually end up paying credit card interest (more on that in a bit).

Types of Credit Card APRs

When you look at your credit card agreement, you may see a handful of different APRs. Here are some to know about:

  • Purchase APR: This is the rate that applies to purchases you make with the card. Keep in mind, though, that if you use your credit card to make a purchase and pay off the full balance during the grace period, you can avoid paying interest.
  • Balance transfer APR: In many cases, the balance transfer APR is the same as the purchase APR. However, balance transfers typically start accruing interest immediately, and there's no grace period like with purchases. Keep in mind, too, that if you move a balance from one card to another, you'll likely be charged a balance transfer fee, which is typically between 3% and 5% of the balance amount transferred. This fee isn't included in the balance transfer APR.
  • Introductory APR: Some credit cards offer an introductory low or 0% APR to give you an incentive to apply for the credit card and to reward you for using it. This low promotional rate for all new purchases, balance transfers or both is available for a set amount of time—at least six months but sometimes as much as 21. When the introductory period ends, the APR will increase, in turn increasing the cost of using the credit card. Your APR may also increase if you trigger the penalty APR by violating 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.
  • 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 and balance transfer rates. And like balance transfers, as soon as you take the cash advance, you will begin accruing interest on the amount.
  • Penalty APR: Many credit card agreements include a penalty APR that the company will charge if you fall behind on payments by 60 days or more. With business credit cards, however, you can trigger a penalty APR if you're late by just one day (though terms vary from card to card). All the balances on your account will be subject to the penalty rate, which is often much higher than other interest rates.

Where to Find Your Credit Card's APR

Information about the various interest rates and fees associated with a credit card can be found in the "Schumer box."

The Schumer box was created through legislation spearheaded by now-U.S. Senator Charles Schumer to provide consumers with a simple and standardized display with all the pertinent rate and fee details about a credit card.

In 2009, the Credit CARD Act expanded the concept of the Schumer box and added a requirement that credit card companies provide clear information on all credit card statements. This includes how much you'll pay in interest and fees if you opt to pay only the minimum payment amount due every month.

When you're comparing credit cards, you can typically find the Schumer box by clicking on a link from the card's landing page that says something like "pricing and terms" or "rates and fees." You'll also get a copy with your cardholder agreement after you've been approved.

How Is APR Calculated for Loans?

Remember, the interest rate is what the lender charges to allow you to use its funds. But it's not the only cost associated with borrowing. Depending on the type of loan, the APR calculation may also include various other fees you'll be charged.

This is where credit cards and loans differ in how they calculate APR—even if a credit card has an annual fee or other fees, it's not included in the APR formula. With loans, however, the APR truly encompasses the total cost of the debt.

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. APRs for dealer-underwritten auto loans sometimes include compensation for the dealer because it'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.

How to Avoid Paying Interest on a Credit Card

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 interest attached.

You can avoid paying interest every month entirely by paying off the full balance by the due date. Remember, though, that the grace period applies only to new purchases. Cash advances and balance transfers don't come with grace periods, so sidestepping paying interest is not likely unless you have an introductory 0% APR promotion on balance transfers.

If the due date for your payment rolls around and you don't have the funds to pay your balance in full, you will be charged interest on the amount that remains. These finance charges can snowball due the fact you'll be paying interest on your interest charges as well, a practice known as compounding. Compounding interest means you will be charged on everything you owe—the unpaid amount on the card, the previous month's interest and on whatever new purchases you made.

Credit card interest can get dangerous if you make just the minimum payment every month. Let's say you purchase a big screen TV and a new sofa for $2,500 on a credit card with an APR of 22%. If you commit and plan for paying this off in 12 months, your monthly payments will be about $234, and you will pay about $308 in total interest charges.

If, however, you make only the minimum monthly payment—credit card companies calculate this number differently, but we'll say it's $75 for this scenario—you would still be paying on this purchase more than four years later. Not only that, but you'd also pay a whopping $1,399 in interest, making the total cost of this purchase $3,899, or 55% more than the original sticker price.

If possible, make it a goal to pay your balance in full each month to avoid interest. If you have to finance a large purchase over time, consider using a 0% APR credit card to save money.

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.

You can check your credit scores to see where you stand and pinpoint areas that may need some work. Also, get a copy of your credit report to check for errors and items that may need to be addressed.

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.

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