When you borrow money, any interest you pay raises the cost of the things you buy with that money. Credit cards are a form of borrowing, as are loans and lines of credit. Knowing a card or loan’s APR helps you compare offers. It also shows you the true cost of what you are buying. For example, if a credit card has an APR of 10%, you might pay roughly $100 annually per $1,000 borrowed. All other things being equal, the loan or credit card with the lowest APR is typically the least expensive.
How Does APR Work?
When you borrow money through a loan, credit card, or another line of credit, you have to pay interest on the money you borrow. The APR is the total rate you pay every year for that loan or credit balance. With credit cards, the APR and the interest rate are often about the same. Other loans, such as mortgages that require you to pay closing costs, include those charges in your APR. But credit card fees like annual fees and late payment fees do not affect your APR. When you keep a balance on your card, your card issuer uses the APR to calculate how much interest to add to your balance. Many card issuers charge interest using your daily balance. This is the amount of money you owe at the end of each day. To do so, the credit card company divides your APR by 360 or 365 to convert to a daily periodic rate. Suppose your APR is 20%, and you have a daily balance of $6,000 on your card for the month. Your card issuer assumes 365 days per year. How much interest will you incur today? To calculate this, find the daily periodic rate. Then, multiply that daily rate by your account balance: The interest you owe for that day is $3.29. Lenders are required to display your APR (or multiple APRs) on your statement. As a result, you can always see how much debt you have at each rate. If you have questions about those rates, call your card issuer or loan servicer. Your loan paperwork or cardholder agreement describes how lenders can change your rate. Credit card companies must follow the terms and conditions in your agreement. With a loan like a mortgage, you will have to pay an APR. That’s because you own interest on the loan every month until it is paid off. With a credit card, though, you don’t always have to pay interest. Most cards feature a grace period. This allows you to borrow money and pay no interest as long as you pay off your entire card balance each month. If you carry a balance on your card, you pay interest based on the APR.
Nominal vs. Effective APR
An APR can help you understand the cost to borrow money or use a credit card. But it’s not perfect. The number you see quoted from a credit card issuer is a nominal APR. But what if you pay charges like cash-advance fees at an ATM? When you pay additional fees, a more accurate representation of your borrowing costs would be an effective APR. This accounts for fees that raise your card balance.
Fixed vs. Variable APR
When an APR is fixed, the rate does not change over time. A fixed-rate mortgage would have the same interest rate and APR for the life of the loan. Most credit cards, though, have a variable rate. (Some store-brand cards feature fixed rates.) With a variable rate, your rate can rise and fall. This is most often in response to an index like The Wall Street Journal’s prime rate. Even with a fixed rate, your card issuer can change the rate. If that happens, they need to notify you, often at least 45 days in advance. If you have a fixed interest rate, the Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009 requires lenders to notify you of a rate change at least 45 days in advance. That rate generally only applies to new purchases. Federal law also regulates rate changes that lenders use to penalize you when you pay 60 days late (or more).
How Is Your APR Calculated?
Your APR often depends on interest rates in the broader economy. Your lender may add an amount (known as the “margin”) to an index like the prime rate. Add those two numbers together to calculate your rate. For example, lenders may say that you pay the prime rate plus 9%. Suppose the prime rate is 3.25%, and your credit card’s APR is the prime rate plus 9%. Add 3.25% to 9% to arrive at your APR of 12.25%. If your card issuer assumes 365 days in each year for billing calculations, your daily periodic rate would be .034%, which is 0.1225 divided by 365. Mortgage lenders often set your interest rate based on your creditworthiness. They may price your card or loan using both current interest rates and how much of a risk it is to lend you money. Things like a higher income, lower debt, and a good credit score make you less of a risk. The lower the risk, the lower your APR.
Types of APR
A credit card or line of credit may have multiple APRs. This means that you pay different rates, depending on how you use your credit. Suppose your card has a $5,000 balance with a purchase APR of 12% and a $2,000 balance with a cash advance APR of 21%. Your total card balance is $7,000. Your minimum payment is 2% of the total balance, or $140. But you pay $440 this month because you want to eliminate debt. The credit card company must put the extra $300 toward reducing your high-rate, $2,000 cash advance balance.
