How does a credit card's interest rate and APR Work?
Ever wondered what APR means and why it's plastered everywhere on a credit card application? This small but ubiquitous acronym stands for Annual Percentage Rate and it measures the annualized cost of borrowing credit. APR is generally determined as a yearly rate and can be affected by factors like the amount of credit in use and the timing of payments made by the credit holder.
Understanding how a credit card's interest rate and APR work can make all the difference between you being in control of your debt and your debt controlling you. The APR is not a one-time charge on your balance each year. Here's a 101 on how credit cards and APRs work:
What is credit card interest?
Credit card interest is the amount that lenders charge you on your credit card balance. Think of it as the cost for using someone else's money. If you pay off your entire balance within your grace period and have no pending prior interest charges, then you will not have to pay interest during that period. The APR can vary from person to person, even when two people have exactly the same type of credit card. That's because lenders take your credit score and credit history into consideration when determining how creditworthy you are, in addition to other factors such as yearly income, location, and more. This means that maintaining a good credit score could result in lenders offering you lower interest rates on credit cards and loans than if your credit score were low or recently took a hit.
When it comes to credit cards, an APR and the interest rate charged is basically the same. The APR is the annual rate, and the interest rate that you are charged each day is the daily periodic rate, based on your APR.
How is interest charged on a credit card?
The APR dictates the interest you pay on your credit card balance over a monthly statement period.
To calculate the interest, the card issuer will multiply your daily balance with a daily interest rate, which is calculated by dividing your APR by 365 (the number of days in a year), which is then added to your account balance the next day.
The next day it happens all over again, except this time instead of paying interest on just the balance, you're also paying interest on the interest accrued from the day before. This goes on every day, and is called “compounding of interest" and can cause your credit card debt to grow considerably over time.
Here's how credit card interest works: APR: 17%, Daily interest rate: (17% divided by 365): 0.047%
Balance day one: $1000, Interest day one: $0.47, New Balance: Balance + interest rate: $1,000.47
Balance day two: $1000.47, Interest day two: $0.47, New Balance: $1000.47 + $0.47 = $1000.94
By the end of the month your interest costs have added $14.26 to that $1000 you've spent on the credit card. By the end of the year, compounded interest costs have added $185.26 to your original $1000 balance if unpaid.
Banks will give you at least a 21-day grace period to pay your balance in full each month. So if you pay off your balance within the grace period, you won't be charged any interest at all. You can keep up with your payments by enrolling in your bank or credit card's automatic payment system, which deducts a specified payment of your choice from your checking account on a schedule.
How does APR work?
A credit card APR comes in two forms:
- Fixed APR: This means the APR you're being charged remains the same, as long as you pay your monthly credit card bill on time.
- Variable APR: This is an APR that follows the changes in the "Prime Rate."
What is a Prime Rate?
The Prime Rate is the benchmark used by lenders and banks to set interest rates for lines of credit commercially in the U.S.
The Federal Reserve Board will change its Federal Funds Rate (on which the Prime Rate is based) from time to time, to make money more or less expensive for consumers and businesses to borrow. Increasing and decreasing interest rates (and therefore the cost of borrowing money) is one way the Fed tries to manage the growth of the economy. Its aim is to keep inflation (prices) from neither getting too high nor too low, so consumers and businesses can make long-term financial plans.
In short, what the Fed does can affect your day to day expenses. That's why news outlets focus so much on what the Fed is doing.
APRs are applied in different ways on different types of transactions:
- Purchase APR: The interest rate applied to things you buy with your card.
- Balance Transfer APR: The interest rate charged on just the balance you transfer from one credit card to another.
- Penalty APR: the rate of interest you're charged if you miss one or more payments or break any of the other terms and conditions you agree to when you apply for a card.
- Introductory APR: a low or zero interest rate that's charged for a set period of time. A higher APR is typically charged on all purchases and balance transfers after that set time expires.
- Cash Advance APR: the amount of interest charged on any cash you withdraw from your credit card account. This APR is usually higher than your purchase APR.
APR may be calculated and applied differently when it comes to other types of loans, such as auto loans or mortgages. Be sure to go over the terms of specific APR with your lender before signing and committing to the loan.
Understanding how credit card interest is calculated and how it is applied to your card can go a long way to appreciating the power of paying balances down to zero each month.
But even if paying down to a zero balance is not possible, try paying down the balance during the month, whenever you can, so that you end up paying off more than just the minimum payment due each month. This could help to reduce the amount of compounding interest, and help you live a healthier financial life.