Two people can apply for a credit card from the same bank and receive a card that looks the same in the mail. But the price you pay to use these cards will be very different if they have different APRs. To find out how much a credit card costs and compare it to other cards, you need to dig into the details of how the APR works.
What are the credit card interest rates?
Credit card interest rates are the prices that financial institutions charge to lend you money.
When you buy something with a credit card, you are borrowing money from the bank that issued the card. The bank pays the merchant to buy you up front. Later, the bank sends you a statement detailing how you use the card and how much you owe, and when you repay the bank. The interest rate is the price you pay for using the card if you don’t pay the balance in full by the statement due date.
Financial institutions charge interest on credit cards because it’s one of the many ways they make money. Another reason they do this is to manage the risk of borrowers not paying back whatever they borrow on the card. During the application process, the credit card issuer will assess the likelihood that the borrower will not be able to pay off the balance (i.e., credit risk) during the application process. This will affect the potential revenue expected from any power balance for the card and, as a result, the level of debt that charges the card.
Banks charge interest as a percentage rate so the more cardholders borrow and carry their cards, the more they pay. Someone who doesn’t use a lot of cards or just pays off the entire balance each month is debt free. “Interests really need to make sure they charge people who actually borrow money and not people who don’t,” said David Shipper, strategic advisor in the Banking & Retail Payments practice at Aite-Novarica, a consultancy. companies that work with financial institutions.
Banks charge different APRs to different cardholders, with lower APRs to cardholders the bank deems to be more reliable borrowers.
“Essentially the bank has been forced to try to figure out, ‘Is this person going to pay us back or not?'” said Rachel Ehrlich, COO of Klutch. “Credit scores are created to help banks be precise.” Banks use your credit score plus factors such as income and location to estimate your credit risk. Some banks may consider the amount you have deposited in a savings or investment account with them.
How APR works
APR on a credit card is an interest rate expressed as a rate for one year. Declaring interest rates in this standardized way allows consumers to easily compare rates between different cards. By law, credit card issuers must provide you with a disclosure showing your APR when you apply for or open a credit card, and they must display the APR on your account statements.
Banks do not charge credit card interest every year. However, most apply a daily periodic interest rate, which is the APR divided by 360 or 365 days, depending on the formula used.
Banks usually give you a grace period, which is a period of time after you buy a credit card when you don’t have to pay interest. The grace period until your monthly payment is due is at least 21 days after the bank sends you an account statement. If you pay your entire balance on the due date, the bank does not charge you interest on your purchase.
If you don’t pay the entire balance by that date, you lose the grace period and the bank starts charging interest on the outstanding balance. Now, all new purchases you make earn interest immediately.
You may be able to recover your grace period by paying your balance in full each month. The bank will not restore the grace period until you pay off the entire balance for two consecutive months.
To determine the interest you owe, the bank usually calculates your balance on the first day of the billing cycle at a periodic daily rate to calculate the interest for that day. Then, add interest to the balance for the next day. This repeats the process every day in your billing cycle. Adding the daily interest gives you the total interest you owe for the billing period, which appears on your statement.
When banks use this method to calculate interest, the interest you owe is compounded daily. This means that you are charged not only for the amount borrowed, but also for the interest from the previous day that you have not paid. The result is that if you have a balance for a year, the percentage of the balance you pay in interest will be higher than the stated APR because the APR figure does not take into account how often the interest compounds.
Is APR good for credit cards?
The best credit card rate is the prime rate, which is the rate banks pay to borrow money every night. Banks set these rates based on the federal funds rate. A bank that values your business may offer you this rate without a markup. “This is the level for the most credit, the biggest customers the bank has,” said Herman “Tommy” Thompson, Jr., certified financial planner and financial planner at Innovative Financial Group.
For others, banks charge an APR equal to the prime rate plus a margin.
Banks offer most people approval for credit card APRs above 20%, so an APR below 15% is a reasonable rate in comparison. But even good credit card APRs are usually higher than banks’ rates on other forms of lending. “Most credit cards just have bad rates,” says Thompson. “If you have decent credit, the bank will do a loan secured by the assets you have, or even just a signature loan that is usually less than half of what you would pay on a credit card.”
How to avoid paying APR
You can avoid being charged APR by paying your balance in full and on time by the due date each month. If you can’t do that, you can try to find another card with 0% APR for balance transfers. Transferring your balance can give you more time to pay it off before the APR kicks in, but keep in mind that you’ll typically pay a 3% to 5% balance transfer fee.
Another option is to get a debt consolidation loan with a lower APR and use it to pay off your balance, but again, fees will apply.
If you have a balance on the card, making payments more often than once a month can reduce the interest charged. “You can actually pay off your credit card any day you want, there is one day you have to do it,” says Ehrlich. “The more you pay off your balance, the less interest you pay.”
Before opening a credit card account, pay attention to the APR and consider whether you can afford it.
“A lot of people think they’re not going to have to pay interest rates, so they don’t have to worry about it,” Ehrlich said. “But it’s a very important factor. So I wouldn’t ignore it or be too sure, because the majority of people have to pay interest rates at some point during the life of their credit card.
Fixed vs variable APR
A credit card’s APR can be “fixed,” meaning it doesn’t go up and down with the bank’s borrowing costs—at least not for a set period of time. Your bank can change this rate if you give 45 days notice.
Most credit card APRs are variable. They fluctuate with the prime rate, and the bank does not have to give heads up that the rate is changing. Your account statement will note any changes to your variable rate. It will also tell you the upper and lower limits on the APR.
What are the different types of credit card APRs?
Generally, credit cards come with a range of APRs that apply to different situations.
- Buy APR: These are the rates that usually apply when you use your card for everyday purchases. “That’s the main thing that’s registered,” Ehrlich said.
- Advance APR: This APR is charged when you write a check from your credit card account or use your card to withdraw money from an ATM. “Usually a cash advance will have a higher APR because it’s a riskier thing for the bank or credit card company to do,” Ehrlich said.
- Introduction APR: Banks generally offer 0% purchase or balance transfer APR for a year or two after you’re approved for a new card. “It’s really about persuading you to use your card and open an account,” Shipper said. After that, you’ll be charged your regular approved purchase APR based on your credit.
- Balance transfer APR: Banks also charge a special APR for balance transfers. This is a promotional rate that applies for a limited time to the balance that has been transferred to the card. .
- Penalty APR: Missing a payment, making less than the minimum payment, or exceeding the credit limit can trigger a penalty APR, which is usually the highest APR the bank can apply on the card. This APR is intended to incentivize you to pay off past due balances quickly and to offset the risk of default on the account.
How to calculate credit card APR
To understand how the APR is applied to the credit card balance, it can help to look at the example.
To get started, you need to find the daily periodic rate for the card, which is the APR divided by 365 or 360, depending on how your bank works. Your card member agreement will show you how the bank calculates the daily periodic rate and will tell you what the rate is.
For example, let’s say your APR is 25% and your bank divides that rate by 365 days.
Then the daily periodic rate is 0.25365 = 0.00068.
So you have a daily periodic rate of 0.068%.
Next, calculate the average daily balance for the billing cycle. To keep it simple, we will assume no grace period.
For example, you start the month with a balance of $800, and you have a balance for 10 days. Then, let’s say you top up $400 on your card, bringing your balance up to $1,200. Your balance remains at that level for another 10 days. Next, you make a $200 payment and your balance drops to $1,000. Your balance remains for the next 10 days.
To find the average daily balance, add the balance and divide by the number of days in the billing cycle. Here, it is $800 x 10 + $1,200 x 10 + $1,000 x 10 / 30 = $1,000.
So your average daily balance is $1,000.
Next, use this formula to find the interest you owe for the month:
Interest = Daily periodic rate x Average daily balance x number of days in the billing cycle
That’s 0.00068 x $1,000 x 30 = $20.40.
In this example, you owe $20.40 a month.
If multiple APRs apply, such as if you charge purchases to the card and also take cash out, the bank will calculate interest on each type of balance separately.
Note that this is a simplified example. Banks often add credit card interest on a daily basis, so that interest on one day’s balance is added to the next day’s balance. That makes the actual math banks use more complicated.
Our math gives a good estimate of the interest over the month, but it will be less accurate over time as the compounding adds up.
Takeaway
Credit cards offer convenience, but they are not free. Your card’s APR is the price your bank sets for carrying a balance. Before you charge anything to your credit card, make sure you know the APR. And ideally, you should pay the entire balance on the due date because you have no debt.