You see it all too often — credit card advertisements for the latest and greatest rewards cards that promise cash-back and endless points you can use towards travel, dining, and entertainment. And then slipped in at the side of the screen you’ll notice some fine print regarding the credit card’s APR. Today we’re here to answer the lingering question we’re all thinking: “How does APR work?”
Before signing up for a credit card, you should always have the annual percentage rate (APR) at the top of your mind. APR amounts will dictate how much interest you’ll be paying on borrowed money. It’s a clear indicator of whether or not you should go through with borrowing money from a certain lender.
In this guide, we’ll tell you all about annual percentage rates — what they are, how they work, and the different types of rates you should look out for. We’ll also show you how you can shop around and secure the best APR.
What Is an Annual Percentage Rate?
The annual percentage rate is the interest you’re charged when borrowing money via loan or credit card. Annual percentage rates can be fixed or variable percentages and can be either simple or compound interest.
As the saying goes, nobody gets a free lunch. If you’re in the market for borrowing money, there are countless lenders and credit card companies looking to do business with you. In exchange for the convenience of borrowing money from a lender — whether that be an auto loan, revolving credit loan, or using a credit card — you’ll be charged an annual percentage rate. Think of it as the cost of borrowing money.
If you’re paying off your credit card in full every month, then you don’t need to worry about your APR too much. But if you’re keeping a credit card balance — especially a high balance — then a high APR may stifle your efforts to quickly pay off debt.
Let’s take a look at how APR works.
How Does APR Work?
Annual percentage interest rates are what you’re charged for borrowing over the course of one year. You can use your APR to figure out what you’re required to pay on a monthly basis, which is known as your periodic interest.
Before signing up with a credit card issuer, you should determine if it has a payment grace period. A grace period allows you a set amount of time to pay off what you borrowed before you’re charged interest. Most credit cards will have a payment grace period. However, not all do — so make sure you check.
If you carry a balance over to the next month, you’ll be charged interest on the money you borrowed. This will be your periodic interest. Periodic interest is what you’re charged each billing cycle. Most credit cards will charge you interest on your average daily purchases over a billing cycle, which is generally one month long.
You can use this basic formula to calculate what your periodic interest will be:
APR ÷ 12 months x Balance = Interest Charge
Let’s say you have a credit card that has a 17% APR. You racked up $500 on your monthly credit card bill. If you paid off the entire $500 balance on your monthly payment, then you wouldn’t have been charged any interest.
If you didn’t pay your full balance, then you’ll be charged $7.08 interest using the following equation.
17% APR ÷ 12 months x $500 Balance = $7.08 Interest
It’s important to know that most credit cards will have variable interest rates. This means that you may have different APRs for different types of transactions. We’ll discuss the different types of APR in further detail below.
You’ll always be notified of your APR before signing up for a credit card. Keep an eye out for fine print and educate yourself on the different APRs for different types of transactions.
You should also be on the lookout for the type of loans you’re taking out and whether they use simple or compound interest.
Simple vs. Compound Interest
It’s important to understand the difference between simple and compound interest. Securing a simple interest loan rather than a compound interest loan is financially beneficial for you.
Simple interest rates are more appealing because you won’t be charged additional interest on the interest you’ve accumulated on borrowed money. This means that when you make a payment, your payment will be applied to your interest balance with the remainder going towards your loan principal. Student loans and auto loans are two types of loans that typically use simple interest.
On the other hand, compound interest loans will require you to pay interest on your interest. This means that if you’ve accumulated interest on a loan, your interest rate will apply to the principal balance and your interest balance. Credit cards typically have compound interest rates.
Compound interest rates can be a slippery slope if you aren’t careful. Your principal and added interest can quickly compound exponentially if you’re slow to pay off your debts. To combat the pitfalls of compound interest, you should always try to pay off your entire balance to avoid any interest charges.
Now let’s go over the different types of APR you may encounter.
Different Types of APR
A fixed APR is one that doesn’t change, regardless of the type of transaction you make. Most credit cards use variable interest rates. Variable APR changes depending on the type of transaction.
Here are several types of APR you should keep an eye out for.
- Purchase APR: This is what you’ll pay for every purchase you make if you maintain a balance. It’s also the most common type of APR.
- Introductory purchase APR: These are promotional APR rates that lure in new borrowers. For example, companies will offer 0% APR for your first six months as a customer. Beware of lucrative introductory APRs that mask a much higher APR rate once the promotional period is over.
- Balance transfer APR: Credit card companies will sometimes give you a different APR if you transfer your balance to another card they provide.
- Introductory balance transfer APR: This is the limited-time promotional rate you’ll receive if you decide to transfer your balance to a different card.
- Promotional APR: These are credit card offers granted for a set period of time on certain purchases. They are pretty much the same as introductory rates.
- Penalty APR: You may be penalized with an increased APR if you fail to make payments for a set period of time. You can avoid penalty APRs by always paying your bill on time and not exceeding your credit limit.
- Cash advance APR: You’ll be charged a separate APR if you borrow cash from your credit card account. This rate is generally higher than your standard APR.
Now that you know what annual percentage rates are and understand the different types of APR, let’s see how you can secure the lowest APR possible.
How to Get a Low APR
APR charges are almost inevitable. However, there are ways to alleviate the pain of paying interest on your borrowed money. For example, if you pay off your credit card balance every month on or before the due date, then you’ll never need to worry about paying a hefty APR fee.
You can also lessen the burden by maintaining a good credit score. This will open doors to lower interest rates. But don’t worry if your credit report has a few blemishes; there are other ways you can secure a lower APR.
You can also look into transferring your credit balance to another card with a lower APR. You should always shop around for credit cards that may offer lower interest rates than the one you currently have. You may also receive an introductory balance transfer APR if you take this route.
Another way is to simply call up your current lender and ask for a lower credit card APR. You may receive a lower rate if you’re a loyal customer and don’t have any late or missed payments.
Understanding the Power of High APRs
Before you decide on a credit card, make sure you do your due diligence and compare the different annual percentage rates that are currently being offered. Some credit cards may be tempting with all of the perks, rewards points, and cash-back options. There are a lot of bells and whistles used to lure in new borrowers.
As long as you borrow responsibly and remember a few of the tips we mentioned above — like paying off your entire balance every month — you should be in good hands. Credit card debt can be a sneaky beast, so be aware of the power of compounding interest and high annual percentage rates.
If you ever want to know what your current credit card interest rate is, you can look at your monthly statement, where it will be listed.