Understanding Credit Card APRs & Interest Rates

The Annual Percentage Rate (APR) is the bank’s terminology for interest – a fee you must pay for borrowing money from your financial institution. The language surrounding APR is everywhere – you see offers on billboards and in the mail. However, it isn’t immediately obvious to most of us how exactly credit card APR works. We’ve all been conditioned to understand the basics: that the lower the APR the better. There is much more nuance, however, to the topic at hand. This guide will walk you through everything you need to know about credit card APR.

Credit Card APR Overview: Types

APR is a representation of the interest rate. However, the two are not exactly the same. As the name suggests, APR is an annualized term. As many of you are probably aware, interest doesn’t wait around a whole year before it kicks in. In fact, most credit cards will compound interest on a daily basis. We explain how to convert APR into an effective interest rate (which is what you actually pay) below. Here we'll focus on giving you an idea of the total scope of APR - from its different forms to when it applies.

If you’ve looked at the terms & conditions of a credit card, you’ll notice that there is a number of different APR rates. These all apply to different ways in which you choose to take out credit with your financial organization:

Purchase APR. The APR that will be applied to all purchases you make with your credit card. Pretty self-explanatory, as far as these terms go. This is the most common interest rate, and the one we tend to think of first when looking at credit cards.

Balance Transfer APR. If you moved or transferred an old balance onto your new credit card, it will be charged this APR. While uncommon, it is possible for the balance transfer APR of a card to be greater than the Purchase APR.

Penalty APR. If you become delinquent in credit card payments – that is, if you don’t pay the minimum amount due for 60+ days – all the balances on your account will begin getting charged this rate. As you might have guessed, this is not a favorable deal – unless you’re the bank. Penalty APR is significantly higher than any other interest rate. The typical penalty APR is 29.9%. This number is no coincidence – banks are not allowed to charge you an interest higher than this. We will explore this topic more in a section below.

Cash Advance APR. If you use your credit card to get funds (via an ATM withdrawal, etc.), you will be charged this rate of interest – separate from all the others. This is usually not as high as the Penalty APR, but tends to be greater than purchase/balance transfer APRs. What makes cash advance APR a dangerous foe is that it does not come with a grace period. That is, you start getting charged the cash advance interest the day you take it out. We explain what a “grace period” is in the section below.

APR Grace Period

Banks will grant credit card users a so-called “grace period”, a time during which they can pay off their balances without getting charged interest. As noted previously, most banks will accumulate interest on a daily basis, using a method called average daily balance. If you manage to pay off your balance in the grace period, which is usually around 25 days, you will get to skip paying interest on that balance. This is why we usually recommend individuals who use credit cards to always pay off their balances at the end of each billing cycle.

What Determines Credit Card APR?

Credit card APR is based entirely on what your bank calls "credit worthiness" - in other words, your FICO score. Most 'Pricing & Condition' disclosures you see will list several different APRs. Those represent the range of interest rates you may be charged, depending on your score. Generally, higher FICO scores correspond with lower APR. Below you can see a sample credit card agreement; the APR section is usually listed first.

This image shows where you can find details about the APRs for your purchases, balance transfers, etc.

A bank cannot suddenly raise or lower your APR without proper notification. The only exception, as noted above, is if you have become delinquent in your payments, at which point the Penalty APR kicks in.

You should also note that all APR is based upon what is called the Prime Rate. This is a figure which is ultimately decided on by the U.S. Federal Reserve. If the Federal Reserve chooses to raise the Prime Rate, it is possible (and likely) for your credit card APR to then follow suit.

What is an Average Credit Card APR?

Typical credit card interest varies greatly between different issuers, brands, and credit card types. Some credit cards are designed specifically to have low interest rates, while ones that focus on providing consumers with rewards tend to have higher APR. You can view the average APR by type, using the table below.

Card Type Type Low High Overall
Travel Rewards Cards  15.15 22.19  17.89
   Airline  14.74 22.34 18.09
   Hotel  14.99 20.60 17.09
Business Credit Cards  13.33 20.08  16.00
Cash Back Credit Cards  14.01 21.67 17.48
Student Credit Cards  15.21 23.33 18.69

How Does APR Affect Your Bill?

APR affects your bill by accumulating interest over time and by being applied in a certain order to different portions of your balance when you're making payments.

The first bit of this information will come as no shock to most readers. APR, a card’s interest rate, will have a direct impact on how much you pay – provided you carry a balance. At the end of each month, a certain percentage of your outstanding balance will be added to the total. This essentially acts as a ‘fee’ the bank charges for having extended your credit.

When you make a payment, the bank applies it in a certain order: the minimum payment is usually applied to the lowest APR balance, and all other payments go towards the highest. For example, imagine that your total outstanding credit card balance is $1,000, with a minimum payment of $100. Of that balance, $500 is accumulating 15% interest, and the other half has an interest of 24%. If you write a check for $500 to your bank as payment, $100 will go towards paying the 15% balance, while the other $400 will pay down the 24% balance.

How to Lower Your Credit Card APR

The previous sections have, no doubt, made you realize how bad having a high APR is for carried balances. Luckily, there are a number of ways to escape high credit card APR.

You can consolidate your credit card debt, by moving your balance due over to a 0% intro APR balance transfer credit card. These cards are specifically designed to help consumers pay down out-of-control debts. The best balance transfer credit cards will offer 0% APR for 15-21 months, from the time of purchase. Make sure, however, not to buy anything using these cards! That's because the credit card will typically have a higher purchase APR, which gets paid off at the very end because of the payment order priority. If you buy something on a 0% APR card, and make a payment, it will be applied to the 0% transferred balance first. You will have to pay interest on your new purchases until you completely manage to pay off the transferred balance.

If your APR was raised as a result of payment delinquency, it doesn’t have to stay high. If you have been making at least the minimum payment for several billing cycles, and your credit score has improved, you can formally request that your bank re-evaluate your rates. While your APR is not likely to rebound immediately to the state it was at before a delinquency, you still have the chance to decrease even a little bit.

APR vs Interest Rate: How to Calculate Credit Card Interest

Unfortunately, the way in which APR is expressed is not very intuitive. Knowing your credit card charges 15% interest, for example, doesn’t give you an immediate understanding of how much interest you will pay on your next month’s bill, if you have a balance of $5,000. In this section, we will work through an example of how credit card interest is determined, in order to show you how to calculate actual credit card interest from APR.

To calculate credit card interest for the month, you must use the following formula (with a few variations included):

Total Credit Card Interest for Month = Balance x Daily Periodic Rate x Number of Days in Billing Cycle

You might wondering: where is the APR in that formula? It’s in there, just hidden. The key figure used in calculating your monthly interest is called the Daily Periodic Rate (DPR). This is because, as stated previously, interest is accumulated daily, while APR is the annual periodic rate. Therefore, to obtain your DPR you simply divide APR by the number of days in a year. Which, assuming the rotation or revolution velocities of Earth do not change, is 365 days. Therefore, we can rewrite the above formula as:

Total Interest = Balance x (APR / 365) x Number of Days in Billing Cycle

The number of days in a billing cycle is the simplest term. It’s just the number of days between bills. Therefore this number will vary with the number of days in a month.

The term “balance” is the most confusing topic that deserves its own article. It’s really a placeholder for one of many different terms, such as “average daily balance” or “adjusted balance”. Different financial institutions will have different ways of calculating that balance – the two methods we mentioned here are the most common. Average daily balance, the most common, is calculated by adding up your balance at the end of each day, then dividing the sum total by the number of days in the billing cycle. This means even if you only buy one thing at the beginning of the month, that balance will carry throughout the month when determining interest expense. Therefore, we can once again re-write the formula for interest, with our newfound knowledge of average daily balance as:

Total Interest = Sum of Daily Balances X (APR / 365)

You’ll note that the number of days in a period canceled out, after we combined the two formulas. The result is nice and simple. If your balance has more than one APR, the result is a little more complicated. Total interest in that case is just the sum of the above formula, for each individual APR and balance. We can write that in an elegant way using the following formula: ∑ Balance_n x (APR_n / 365), where n is the number of APRs and their corresponding balances.

Let’s get back to the example we had in the beginning of this section. Say you have an APR of 15%, and a balance of $5,000. For simplicity’s sake, we will assume that you made that $5,000 charge on the last day of your billing cycle. In that case the interest paid will be: ($5,000) x (0.15/365) = $2.05.

Why is Paying APR a Bad Deal?

If you read the above example, you may get the impression that APR is a joke. A $2 fee on a $5,000 line of credit doesn’t seem so bad. It comes out to just 0.041% of the total. However, don’t forget that we assumed the purchase was made at the end of the billing cycle – you effectively paid it off the day after your purchase. But, think about what happens if that same scenario is changed slightly. Instead of making that $5,000 purchase at the end of the billing cycle, you make it at the beginning. The sum of daily balances equals $125,000 (assuming a 25 day billing cycle). The interest rate, therefore, becomes $125,000 x (0.15/365) = $51.40! The interest all of a sudden goes from being just 0.041% of the total, to 1%!

By paying interest, you are paying more for items than they are worth. Let’s continue with our example from above. If you bought a $5,000 TV, you probably did so because you deemed it to be worth $5,000. However, if it takes you a long time to pay that item off, and by the time you are done, you have paid $200 in interest, that purchase ended up costing you a total of $5,200. It’s an often overlooked concept. It is important that we understand the true cost of the items and services we purchase – otherwise, we might end up making a decision we otherwise would not have, given all the information.

This is why we always urge our readers to pay off their credit card balances in full – before interest is charged. Small purchases like socks, meals, and movie tickets are rarely worth more than what you are paying for them. Therefore, paying interest on top of that price is a bad deal.

Comments and Questions