How Does APR Work? Understanding Credit Card Interest Rates

April 30, 2019 by  
Filed under Credit card

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In America, little is as important to your financial future as your credit history and score. Most people in the United States have between two and four credit cards with an average debt of over $6,000. Adding to that, 83 million people take a personal loan every year. The average personal loan is $7,500. Every credit card and loan collects additional payments each year that is called an Annual Percentage Rate (APR). Borrowers who don’t take the time to answer the question, “How does APR work?” will sometimes find themselves struggling to pay off their debts. Understanding APR helps borrowers know the true costs of their loans and credit card debts. With that knowledge, borrowers can make the best decisions to pay down debt and build great credit.

What Is APR?

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In the simplest terms, APR is what you must pay in return for the money you are credited. It is determined as a percentage of the money you accrue in credit card debt or personal, auto, payday or mortgage loans. It is added into the minimum monthly balance you will see on your monthly statement. For credit cards, there are often a number of different APRs that you will be responsible for paying. It’s important to understand these different rates when figuring out exactly how APR works.

INTRODUCTORY APR

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This is the rate that borrowers are often quoted when they shop for a new credit card. The introductory APR can be as low as 0%. Pay attention to the length of the introductory rate. If your introductory rate only lasts for 6 months and suddenly rises to 24% or more, you might end up paying more the first year than you would with a fixed-rate APR.

BALANCE TRANSFER APR

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Some cards offer a special low-rate for debt that you transfer from a different card. This is called the balance transfer APR. If you’ve developed a large balance on a credit card with a high-interest APR, you might be able to find a card with a great balance transfer APR. You can pay off your debt quicker and with less money if you are able to find a low rate for balance transfers. However, borrowers with poor credit might have a harder time getting approved for these low rates and will have fewer options available.

PURCHASE APR

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The Purchase APR is the rate that you pay on all purchases made with the card. This is the typical APR that is advertised if there is no introductory APR for a credit card. The average credit card purchase APR is a little over 17% but those with bad credit might pay 24% or more on purchases.

CASH ADVANCE APR

Many credit cards offer the option of withdrawing cash from ATMs. What many borrowers don’t realize is that the rate they pay on these “cash advances” is different from — and often higher than — either their introductory or purchase APRs.

PENALTY APR

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Missing payments is one of the worst things you can do, both for your rates and your credit. When you miss payments on a credit card balance, you might be required to start paying the highest possible rate on your card. The introductory rate and purchase APRs that you were sold on could disappear. The best tactic is to avoid missing payments so that you don’t have to worry about the Penalty APR.

EFFECTIVE APR

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The effective APR is the single most important APR to understand when asking, “how does APR work?” When you understand your effective APR, you will fully understand how much your loan or credit card debt is costing you. Because of how different rates are calculated, two advertised APRs that look exactly the same can end up costing you vastly different amounts. Learning the details for how APR works will help you calculate your effective APR.

How Does APR Work?

A few factors are used in calculating APR and should be considered when answering the question, “How does APR work?”. Credit card and loan companies are required to provide you with information on their APRs, fees, and policies prior to doing business with them. After you get your new credit card or loan, your APR and fees will be added into your minimum monthly payment. This means your monthly payment is for more than just paying back what you’ve spent or received. APRs tend to function a bit differently for loans and credit cards. We will examine how the APR for each of these works.

LOAN APRS

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The APR for loans tends to be fairly straightforward. For the average $7,500 personal loan with a 16% APR, a borrower should expect to pay more than $1,200 in interest over the first year. This is in addition to payments on the loan itself, or the principal of the loan.

It’s important to take fees and term periods into account to determine your effective APR. Payday loans are one of the biggest culprits of deceptive APRs. Many of these loan companies attach fees to each $100 borrowed for payday loans. Some states place restrictions on these, limiting fees to $10 or $30 per $100 of the amount borrowed.

Most of these fees operate on a two-week term, making the annual percentage rate balloon. The average payday loan is $350 and the average payday loan fee is $15 per $100 borrowed. Based on this rate, a borrower would owe the original $350 plus $52.50 two weeks after receiving the loan. The annual percentage rate would equal a staggering 390%. This is why many experts strongly advise borrowers to avoid payday loans at all costs. Even the worst personal loans and credit card rates are required by law to be significantly lower than you will find with payday loans.

CREDIT CARD APRS

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The APR for credit cards, as you might suspect after seeing the variety of APRs, can be somewhat more complex than it is for loans. If you are still in an introductory period for your credit card’s purchase APR, you won’t have to worry about paying any interest for balances you carry from month to month. More importantly, if you pay your balance in full each month, you will not pay any interest, making your APR effectively 0%.

More often, those with balances can have multiple APRs at play in their monthly statement. So how does APR work in this situation? If a borrower transferred $2,000, used the credit card for an additional $5,000 in purchases, and then withdrew $500 as a cash advance, figuring out how APR works gets even trickier. Assuming a balance transfer APR of 5%, a purchase APR of 16% and a cash advance APR of 25%, the borrower will pay more than $1,025 in interest over the first year. This is effectively less than the expected 16% purchase APR. However, if we flip the amounts for the balance transfer and the cash advance, the borrower will owe more than $1,325, raising their APR higher than the purchase APR.

Take fees into account when determining your effective APR. If you plan to pay off your balance in full each month, it may make more sense to choose a higher APR credit card option with zero fees, than a lower APR credit card with $99 in annual fees and additional monthly fees.

As stated, these are just the foundations of understanding your credit card’s APR. To figure out your effective APR you must also take into account the way that interest adds to your balance over time.

COMPOUNDING INTEREST

Loans and credit cards don’t charge your interest rate once per year. Instead, your APR is divided by 365 to determine the daily percentage rate. Every day that you carry a balance, your interest is calculated based on that daily rate and added to your balance. As the owed daily interest is added to your balance, your balance grows, and the new interest creates an even higher effective APR. This is referred to as compounding interest.

Compounded interest is a vital factor to understand when answering the question, “How does APR work?”. The important thing is to remember that when you carry a balance from month to month, you will not only pay the interest on the balance, but you will also pay the interest on your interest. The best thing to do is pay off as much each month as you can so that you have as little compounded interest as possible.

APRs and Credit

When learning the answer to the ever-ominous question, “How does APR work?” many people start to understand how closely linked credit and APRs are. When your credit score rises, the APRs available to you will drop. When your credit score drops, the APRs you can find with credit cards and loans will rise. Once you start sinking into deeper credit card debt with worsening credit scores and higher APRs, it becomes far more difficult to rebuild your credit.

No matter what your credit score is, you want to find the lowest effective APRs available to you. Doing so helps you preserve and rebuild your credit score. As you gain a better credit score, you might be able to transfer balances to credit cards or loans with better APRs. With higher-rate APRs of 24% or more, it’s even more important to understand the effect that compounding interest will have on how well you can keep up with your monthly payments, maintaining or rebuilding your credit.

Conclusion

Every American adult should take the time to learn the answer to the question of “How does APR work?” Millions of people find themselves struggling with unsustainable debt because they did not understand how to evaluate APRs, fees and compounding interest. When you understand how APR works, you arm yourself with the knowledge to make the best choices possible to attain all of your financial goals and build your future.

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