You’ve probably seen the term APR when financing a purchase. Whether it’s a significant item such as a mortgage or auto loan or something small like groceries or clothing. It’s also a very important term when comparing credit cards.
What does APR mean?
The interest rate and annual percentage rate (APR) are often mistaken for each other, but in reality, the APR is just one of the factors that contribute to the overall interest rate. Understanding the true meaning of APR requires taking into account all the elements that affect it. Failing to do so could result in unforeseen expenses exceeding your budget when committing to a loan or credit card.
Even if you take advantage of a 0% introductory rate on your credit card, potential interest charges and fees may apply if you’re unable to pay off your balance entirely. As we all know, finances can be unpredictable and not always go according to plan.
So, it’s critical to arm yourself with the necessary tools to make informed decisions. One such tool is to compare the APRs of various credit offers, which can assist you in selecting the best option for your financial situation.
Annual Percentage Rate (APR): A Basic Definition
Credit card companies charge an annual percentage rate (APR) on any amount not paid before interest is accrued. It includes the actual interest rate as well as any fees that are charged for the purchase.
In essence, the annual percentage rate is the total cost of borrowing money for whatever you are buying expressed as a percentage. The APR will be higher than the advertised interest rate if there are other charges, and it must be included in any disclosures regarding financing.
Because each credit card issuer has its own rate structure, penalties, and transaction fees, it can get confusing to understand exactly how much you are paying for an item. The APR is a simple way to provide a base number for comparison.
How much a person pays in credit card interest and fees determines the total cost of the purchase. You may compare APRs from different products to decide which one is a better deal. Before deciding on a product, it’s essential to understand what an APR includes, how it works, and how it impacts your finances.
The Difference Between APR and Other Numbers
The APR is only one number you will see on transactions. These terms can get confusing if you don’t know what they mean and understand the differences.
Another term you’ll see is the daily periodic rate, which is used to calculate interest rates. It refers to the interest that is charged on a daily basis on your purchase or loan. Basically, it is the APR divided by the number of days in one year — 365. The monthly periodic rate is similar, except the APR is divided by 12.
How does APR work on credit cards?
Here is an example in practical terms.
A credit card (or loan) has an APR of 15%. The daily periodic interest rate would be 0.041%, while the monthly periodic interest rate would be 1.25%. Credit card issuers need to know these numbers because they add interest to your balance on either a daily or monthly basis rather than annually.
Another term is the annual percentage yield or APY. It takes into account the interest that is compounded each month, while the APR does not. For example, say you borrowed $1,000 with an APR of 12%. The monthly periodic rate is 1%, making the interest for that period $10.
If nothing is paid on the principal, the balance goes up to $1,010. The following month, the interest charged will be slightly higher because it is compounded on the $1,010 rather than the original $1,000.
Most credit card issuers offer a grace period. The grace period is the time between the end of a billing cycle and when your bill is due. You are generally not charged interest on your balance during this period as long as you pay it off by the due date.
How is APR calculated?
The APR depends on two factors. First, the U.S. prime rate is the base at which all other interest rates start. This is the interest rate you hear financial experts talk about when determining if the base rate will go up or down.
It impacts all other interest rates. Second, the creditor or financial institution adds a margin rate, which is the amount above the base rate.
This rate may stay the same regardless of the base rate. For instance, the base interest rate may be 4.9%, and the creditor charges a 10% margin for all financing. The interest rate for the customer would be 14.9%.
How to Calculate Your Credit Card Interest
To calculate your credit card interest, you must first determine your outstanding balance. This is the amount of money you currently owe on your credit card.
Next, identify your APR. This is the interest rate charged on your credit card balance per year. Divide this APR by 365 to calculate the daily periodic rate (DPR), and then multiply this DPR by your balance to determine your daily interest charge.
For example, if your APR is 18% and your outstanding balance is $1,000, then your daily interest charge would be $0.49 (0.0493% x $1,000). Multiply this daily interest charge by the number of days in your billing cycle to arrive at your total interest charge for the month.
Floating or Fixed APRs
Many loans have a fixed APR, which means your interest doesn’t change throughout the life of the loan. You will most often see this in a fixed rate home loan, car loans, or personal loans. With some home loans, you may have an adjustable rate, which means it changes once and then sets at a fixed rate for the duration.
Credit cards often use a variable APR (or floating APR), which is set for a specific period of time. It changes as the U.S. prime rate changes, meaning you may pay a different interest rate from when you first signed up for the credit card.
You may also discover that a creditor provides different APRs for various charges. This is most often seen in credit cards. For example, you pay one APR when you use the credit card for purchases and another one (usually higher) if you take out a cash advance. Typically, the cash advance APR is higher than the purchase APR.
What Determines Your APR
Several factors determine your credit card’s APR, which is why it is such a complicated concept. First, the U.S. prime rate directly impacts the APR you’re being charged, as does the creditor’s margin rate. Then, on top of those set influences, other variables affect the specific APR you’re offered for your credit card or loan.
Most importantly, your credit history and credit scores impact whether you have a low or high APR. Someone with a lower credit score pays a higher APR than someone with excellent credit.
To make this fair, creditors must follow specific rules they set in place for all customers. While they can charge customers different interest rates, it must be within its guidelines.
For example, a credit card issuer may charge a 10% APR for customers with a credit score over 700 and a 15% APR for customers with a credit score below 700. However, under this set of rules, they could not charge a 10% APR for one customer with a 705 score and 15% APR for a second customer with a score of 703.
Credit card issuers can also charge special APRs for certain situations. You’ll often see this in practice when credit cards offer a 0% APR for the first 90 days for new customers.
Introductory APR: The introductory APR is in effect only for a limited time, and it may come with restrictions, such as not being available for balance transfers.
Penalty APR: Credit card companies generally have a penalty APR in place for people who make late payments or violate their agreement in some way. This APR goes into effect for all future purchases, but it may be lowered if a customer proves to be responsible with the rest of their monthly payments.
Balance transfer APR: Some credit cards have a special balance transfer APR. You may see ads promoting a zero percent balance transfer rate. This is typically in effect only for amounts transferred from another credit card and doesn’t include new purchases or cash advances.
It is usually only in place for a limited time before a higher APR goes into effect. Pay attention to these details. Otherwise, you could end up paying more for your balance transfers or new purchases.
How to Compare APRs
Comparing the APR to the competition is the only way to know the true cost of a product you are financing. Don’t forget to factor in special charges such as annual fees, as these will influence your APR, though late payments and other fees can’t be calculated in advance.
If you are a loyal customer who has always paid on time, then you may be able to negotiate a lower APR. You can request a review of your account to see if you qualify for a more favorable rate, although banks are not obligated to grant your request. However, if you have a competitive offer from another credit card company, then it is always worth trying.
Negotiating a Lower APR
Negotiating a lower APR can be an option if you are having trouble making your monthly payments. However, beware that the creditor may choose to close your account to prevent you from running up a high balance again.
When taking out a home mortgage, you can choose to pay points to reduce your interest rate. Paying points may be a considerable amount of money upfront, but this could save you a great deal of money over the long-term, as home loans are typically set up for 15 or 30 years.
APR can be a daunting concept, but understanding how it works is essential for making sound financial decisions. Remember to ask questions and read the fine print regarding your APR to ensure you get a good rate.