When you borrow money, whether you use a credit card or other form of financing, you usually have to pay interest to the lender. In the case of credit cards, the rate you pay on your balance is called the annual percentage rate (APR).
You may have seen this term on your monthly credit card bill, but you haven’t fully understood what it means. Unlike an interest rate, an APR incorporates the interest and fees you pay to borrow money. There are several types of APRs, and the amount of APR you pay can depend on both your creditworthiness and when you pay off your credit card balance.
Keep reading to find out what exactly an APR is, how it works, and how to minimize your interest payments.
What is an annual percentage?
The annual percentage rate (APR) is the rate you pay to borrow money. For credit cards, your APR is the price you pay to have a balance on your credit card. The APR is expressed as a percentage and represents the amount of interest and other fees that you pay on the card over the course of an entire year.
Types of APRs
There are different types of APR, depending on the type of transaction. Here is an overview:
- Introductory APR: Many credit cards come with introductory APRs lower than the card’s normal APR. An introductory APR can be as low as 0%, but only for a limited time.
- Purchase APR: This APR applies to purchases you make on your credit card throughout the month and are not refunded on the payment due date.
- APR balance transfer: A balance transfer involves moving the balance from one credit card to another, often to take advantage of a low introductory rate. When the introductory rate ends, your balance transfer is subject to its own APR which is often higher than the purchase APR.
- APR cash advance: A cash advance involves borrowing money from your credit card balance in the form of a loan. Credit card cash advances often have a higher APR than purchases.
- APR penalty: If you violate the terms of your credit card, for example by missing a payment due date, you may be subject to an APR penalty greater than your purchase APR.
APR vs. interest rate: what’s the difference?
Many people use the terms APR and interest rate interchangeably, but your APR and interest rate are two different things. The APR is often the interest rate combined with other financing costs.
But in the case of credit cards. APR and interest rate are really the same. Whether a credit card advertises its rate as an interest rate or an APR, it’s the same thing. All other fees, such as annual fees and balance transfer fees, are billed separately from the APR.
Fixed vs. variable APR: what’s the difference?
As with any other type of financing, credit cards can come with fixed or variable APRs.
A fixed rate credit card has the same APR the entire time you hold the card. This type of APR can be beneficial, especially when interest rates are low, as they allow you to lock in a low rate for the life of the credit card. You are not vulnerable to rate hikes as the economy changes.
A credit card issuer can still change the APR on a fixed rate card, but that’s more difficult to do. They must meet certain requirements, including giving sufficient notice to cardholders.
A variable rate credit card is a card with an APR tied to a particular index, often the prime rate. As the prime rate fluctuates, so does the APR that credit card issuers are willing to offer their customers.
While it is possible to find a fixed rate credit card, most credit cards have a variable rate. If you prefer a fixed rate credit card, you will likely have to look elsewhere than the major credit card issuers. Instead, look to local credit unions and banks, which are more likely to offer fixed rate cards.
How an annual percentage rate works
An APR usually applies to purchases and balances you don’t pay. At the end of each statement period, your credit card issues a monthly bill. Once your invoice is issued, you have a grace period (usually around 21 days) during which your purchases do not bear interest.
Any purchase on your card that you don’t pay by the due date and the end of the grace period will start earning interest. To calculate interest, banks use a daily periodic rate, which is your APR divided by 365. For example, with an APR of 20%, your daily periodic rate is 0.05479%.
To calculate how much interest you will actually pay, divide your daily periodic rate by the number of days in a billing period, then multiply that rate by the amount of your credit card balance subject to interest.
Here’s how the APR can cost you
Credit card rates are among the highest of any type of financing. It’s easy to get caught up in racking up credit card debt, not paying for your purchases by the due date, and then seeing most of your monthly payments go towards interest in the future.
According to Experian, the average credit card balance in 2020 was $ 5,315. If you had 16% APR on your credit card and only made the minimum payments, you could be paying over $ 6,500 in interest over the life of the card. This is more than the amount you actually borrowed.
“Interest on credit cards can have a huge impact on a consumer’s ability to pay back what has been borrowed, if they’re not careful,” said Shanté Nicole, Credit Coach and Founder of Financial Common Cents. “It’s imperative that you stay in control of your spending, making sure you have the funds to pay back what has been borrowed when the bill is due, not minimum payments to keep you afloat. Each month the balance is carried over past the due date, interest is charged, which can result in much more debt than the borrower had expected. “
The faster you pay off your balance, the less money there is to earn interest on, and therefore the less interest you will pay over the life of the debt. Ideally, you’ll pay off your balance in full to avoid interest altogether, but if you can’t pay more than the minimum, you’ll reduce interest charges.
“Credit cards should only be used for things you already have money for,” Nicole said. “That way you are assured of never paying interest. Once you’ve borrowed money for a purchase, pay in full by the due date. No balance is carried over and no additional fees. is not paid. “
What is a good APR?
According to CreditCards.com, the average rate on a credit card in the first week of August 2021 was 16.22%. You can use this number as a benchmark to help you determine if you are being charged a reasonable rate.
Keep in mind that while the average rate may be 16.22%, that doesn’t mean that’s the rate everyone will qualify for. In general, the APR you qualify for on a credit card or other type of financing depends on your credit score.
In general, the best APRs are reserved for those with high credit scores. For borrowers with lower scores, the average rate is significantly higher at 25.80%. One of the best ways to reduce the amount you spend on interest, besides paying off your balance in full each month, is to improve your credit score.