What is the annual percentage rate (APR)?

Definition and Examples of Annual Percentage Rate (APR)

How Does Annual Percentage Rate (APR) Work?

How Is Your Annual Percentage Rate (APR) Calculated?

Types of Annual Percentage Rate (APR)

Definition and Examples of Annual Percentage Rate (APR)

The annual percentage rate (APR) for a loan is the total amount of interest you pay annually. This is calculated before compounding interest is factored in. The annual percentage rate (APR) is expressed as a percentage of the loan balance.

When you borrow money, any interest you pay increases the cost of the things you buy with that money. Credit cards are a form of borrowing, as well as loans and lines of credit.

Knowing the annual percentage rate (APR) for a card or a loan helps you compare offers. It also shows you the true cost of what you are buying.

For example, if a credit card has an annual percentage rate (APR) of 10%, you might pay about $100 annually for every $1,000 you borrow. All else being equal, a loan or credit card with the lowest annual percentage rate (APR) is usually the least expensive.

How Does Annual Percentage Rate (APR) Work?

When you borrow money through a loan or credit card or another line of credit, you have to pay interest on the money you borrow. The annual percentage rate (APR) is the total rate you pay each year on the loan balance or credit balance.

In the case of credit cards, the annual percentage rate (APR) and the interest rate are usually closely aligned. Other loans, such as mortgages that require you to pay closing costs, include those fees in your annual percentage rate (APR). However, credit card fees such as annual fees and late fees do not affect your annual percentage rate (APR).

When you carry a balance on your card, your card issuer uses the annual percentage rate (APR) to calculate how much interest will be added to your balance. Many card issuers charge interest using your daily balance. This is the amount you owe at the end of each day.

To do this, the credit card company divides your annual percentage rate (APR) by 360 or 365 to convert it to a daily rate. For example, if your annual percentage rate (APR) is 20%, and you have a daily balance of $6,000 on your card for the month. The card issuer assumes 365 days in a year. How much will you pay in interest today?

To calculate that, find your daily periodic rate. Then multiply that daily rate by your account balance: 20% / 365 = 0.0548% × $6,000 = $3.29

The interest you owe for that day is $3.29.

Lenders must display your annual percentage rate (APR) (or multiple interest rates) on your statement. Therefore, you can always see how much debt you have at each rate. If you have questions about those rates, contact your card issuer or loan service.

Your loan documents or cardholder agreement describe how lenders can change your rate. Credit card companies must abide by the terms and conditions in your agreement.

With a loan like a mortgage, you will have to pay the annual percentage rate (APR). This is because you accrue interest on the loan every month until it is paid off. With a credit card, you don’t always have to pay interest.

Most cards have a grace period. This lets you borrow money and not pay interest as long as you pay your card balance in full each month. If you carry a balance on your card, you will incur interest based on the annual percentage rate (APR).

Nominal APR vs. Effective APR

The annual percentage rate (APR) can help you understand the cost of borrowing money or using a credit card. However, it is not perfect. The number you see listed by a credit card issuer is the nominal annual percentage rate (APR). But what if you paid additional fees, such as ATM withdrawal fees?

When

you pay additional fees, the most accurate representation of your borrowing costs will be the effective annual percentage rate (APR). This takes into account the fees that raise your card balance.

Fixed versus Variable Annual Percentage Rate (APR)

When the annual percentage rate (APR) is fixed, the rate does not change over time.

A fixed-rate mortgage will have the same interest rate and APR throughout the loan term. However, most credit cards have a variable rate. (Some store cards feature fixed rates.)

With a variable rate, your rate can increase and decrease. This usually happens in response to an index such as the prime rate published by The Wall Street Journal.

Even with a fixed rate, your card issuer can change the rate. If that happens, they typically must notify you at least 45 days in advance.

Note: When interest rates rise, borrowing money becomes more expensive. Compare the rates you are paying to the average credit card rates to see if you are getting a good deal.

If you have a fixed interest rate, the Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009 requires lenders to notify you of a rate change at least 45 days in advance. This rate typically applies only to new purchases.

The federal law also regulates changes to the rates that lenders use to penalize you for late payments after 60 days (or more).

How is Your Annual Percentage Rate (APR) Calculated?

Your annual percentage rate (APR) is often based on interest rates in the broader economy. Your lender may add an amount (known as a “margin”) to an index such as the prime rate.

Add these two numbers together to calculate your rate. For example, lenders might say you are paying the prime rate plus 9%.

Let’s assume the prime rate is 3.25%, and your credit card’s APR is the prime rate plus 9%. Add 3.25% to 9% to arrive at your APR of 12.25%. If your card issuer assumes 365 days in a year for billing calculations, your daily periodic rate would be 0.034%, which is 0.1225 divided by 365.

Lenders often determine your interest rate based on your creditworthiness. They may price your card or loan using current interest rates and the level of risk in lending you money.

Factors such as a higher income, lower debt, and a good credit score make you less of a risk. The lower the risk, the lower your annual percentage rate (APR) will be.

Types of Annual Percentage Rate (APR)

A credit card or line of credit may have multiple interest rates. This means you pay different rates depending on how you use your credit.

Rate Type	Description	Important Details
Purchase	The rate you pay for most purchases	If you use your card for online or in-store purchases or to pay bills, this rate typically applies.
Introductory	The rate you can get as a new customer	These rates may start low, but they have an expiration date, and your rate will increase over time.
Balance Transfer	The rate you pay on debts transferred to your credit card	You may start with a low promotional rate and later face an increase in the rate. You may also have to pay a balance transfer fee.
Cash Advance	The rate you pay to get cash from an ATM (or other cash-like transactions)	Rates are high, and you may also have to pay a secondary cash advance fee.
Penalty	Increased rate due to late payment	Your rate goes up, but you may be able to lower the rate through a series of on-time payments.

When
You should pay more than the minimum monthly payment required, as your card issuer generally should apply the excess to the balance with the highest rate. It’s always smart to pay more than the minimum required payment. This is especially true if you are paying high rates.

Let’s say you have a balance of $5,000 at a purchase interest rate of 12% and a balance of $2,000 at a cash advance interest rate of 21%. The total balance on your card is $7,000. The minimum payment required is 2% of the total balance, or $140. But you are paying $440 this month because you want to eliminate debt. The credit card company should apply an additional $300 to reduce the cash advance balance of $2,000 at 21%.

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Sources:

Federal Trade Commission. “Credit, Debit, and Charge Cards.” Accessed June 25, 2021.

Office of Consumer Financial Protection. “How does my credit card issuer calculate the interest I owe?” Accessed June 25, 2021.

Office of Consumer Financial Protection. “What is a ‘daily periodic rate’ on a credit card?” Accessed June 25, 2021.

Office of Consumer Financial Protection. “What is the difference between a fixed interest rate and a variable interest rate?” Accessed June 25, 2021.

Federal Reserve System. “A look at consumer compliance.” Accessed June 25, 2021.

Source: https://www.thebalancemoney.com/annual-percentage-rate-apr-315533