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What Is APR? Your 6-Minute Guide to Annual Percentage Rates

7 min read
Brendan Harkness Michelle Black By Brendan Harkness and Expert reviewed by Michelle Black Jun 11, 2018 | Updated Feb 18, 2020

You’ll hear lots of new terms when you apply for a loan or credit card. Annual percentage rate, or APR, is one you should definitely understand.

What’s the definition of APR? The annual percentage rate is what your lender charges you to borrow money on a yearly basis. It includes both your interest rate and any fees the lender tacks on. Put another way, APR is the annual “price” of borrowing money.

Here’s how APR works in very basic form. Imagine you take out a $20,000 auto loan at 7.5 percent fixed APR for five years and the lender charges you no additional fees. Assuming you make all your monthly payments on time, by the end of the loan term, you’ll have paid your lender about $24,000: $20,000 for the original loan amount and a little over $4,000 in total interest charges. The actual price, or cost, of the loan is close to $4,000.

Of course, credit cards are a bit different. If you pay your balance in full each month by the due date, you can avoid interest on purchases entirely. In this scenario, your APR has no effect on the cost of borrowing money.

What’s the Difference Between Simple and Compound Interest?

When you borrow money, your interest charges are calculated as either simple interest or compound interest. The type of interest your lender or credit card issuer charges can have a big impact on your overall cost of financing.

Many installment loans, such as auto loans and student loans, are simple interest loans. When you make your payment each month, the interest you owe is paid in full and the remainder of your payment reduces the principal loan balance by some amount. If you make your monthly payment early, your interest charges are typically lower and more of the payment goes toward your principal debt.

With compound interest, interest charges are calculated on both the outstanding balance, including new purchases and fees, and the interest charged on that balance. You end up paying interest on your interest.

Most credit cards and revolving lines of credit use compound interest. As a result, you may actually pay a higher APR on your credit card debt than the interest rate listed in your card agreement.

Here’s how it works: Imagine you charged $1,000 in new furniture on a credit card with a 20 percent APR. If the bank only charged credit card interest once per year, you’d pay about $200 in interest ($1,000 x 0.20 = $200), assuming there were no additional fees.

But with many credit cards, interest is compounded on a daily basis. Using the daily balance method, your card issuer would calculate your average daily balance and multiply it by your daily periodic rate (your credit card APR expressed as a daily value: APR ÷ 365). Then, the issuer would add those interest fees to your outstanding balance.

If you don’t pay your credit card balance in full each month, the “interest on interest” fees would effectively drive up the actual interest rate on your card. That’s the hidden danger of compound interest from a personal finance point of view.

The only way to avoid the negative effects of compounding interest on your credit card debt is to pay your balance in full each month by the due date. Card issuers typically offer a grace period, during which no interest is charged on purchases — as long as you pay your statement balance in full by the due date.

What Is a Variable APR Loan or Credit Card?

Just as simple versus compound interest determines the true cost of borrowing money, fixed versus variable APR plays another important role.

A fixed APR means that you pay the same interest rate for the entire term of the loan. With a variable rate loan or credit card, however, your interest rate can go up or down depending on the prime rate or other index chosen by your lender. Variable rate financial products can be attractive because they often come with low introductory rate APRs.

Here’s how variable APR works. Your bank or credit card company pegs the annual interest rate to a financial index. From there, it adds a fixed amount, known as a margin, to determine your APR.

Most variable-rate loans are based on the U.S. prime rate, which is the lowest APR banks charge their most credit-worthy customers. However, other indexes, like the LIBOR (London Interbank Offered Rate), are sometimes used as well.

Imagine the margin on your variable APR credit card is 14 percent. If the prime rate is 4.75 percent, your interest rate would be 18.75 percent (index rate of 4.75% + 14% margin). Depending on the lender and the terms of your credit card agreement, your rate may be recalculated on a monthly, quarterly or yearly basis.

When the financial markets are relatively stable, you may not see huge swings in your variable rate loans. But when the markets are in turmoil, you may see big jumps in variable-rate financial products.

Be sure to find out which consumer protections come with your loan if you are considering a variable rate financial product. In particular, look for interest rate caps, which limit the amount your APR can increase over a particular period of time.

What Are the Different APRs on Credit Cards?

Most credit cards have multiple APRs for different situations. Here are a few of the most common APRs you may see on your monthly statement:

  • Purchase APR: This is the most common type of APR that you’ll see. It’s the interest rate you’ll be charged on purchases if you revolve a balance from month to month.
  • Introductory purchase APR: This is a lower APR that applies to new purchases made for a certain period of time after you open a new account. It’s one of the most popular credit card offers lenders use to attract new customers. You’ll find many cards with 0% APR introductory rates.
  • Promotional APR: Promotional rates are special rates offered for a short period of time or on certain types of balances. Sometimes this term is used interchangeably with introductory APR.
  • Balance transfer APR: Some credit card companies can help you save money with a lower APR on balances you transfer from another card to a new or existing account with that company.
  • Introductory balance transfer APR: Some credit cards designed for balance transfers offer 0% or low intro rates on balances you transfer from other accounts. Usually you need to complete the transfer within a few months after getting your new card to be eligible.
  • Cash advance APR: Most issuers charge a higher APR on cash you borrow on your card than on your regular purchases. You’ll also typically pay a cash advance fee, further driving up the cost of this type of transaction.
  • Penalty APR: In some cases, your credit card company may bump your APR to the highest APR allowed on your agreement. This is generally due to multiple late payments or consistently running a balance above your credit limit. The average penalty APR is around 29.99 percent, and there is currently no law limiting the penalty rate banks can charge. However, the CARD Act does require card issuers to disclose the cost of penalty APRs in advance. After six months of on-time payments, card issuers must also lower your APR back to the standard rate.

There’s something else you should keep in mind about your minimum monthly payments and the different APRs on your credit card balance. By law, the minimum monthly payment must be applied to the highest APR balance on your credit card. Yet, if you pay more than your minimum, that amount can go to balances with lower promotional APRs.

What Can I Do to Get the Lowest APR?

Remember, for most credit cards the purchase APR is irrelevant as long as you pay off your purchases in full each month like we recommend.

If you already have credit card debt and want to reduce the APR you’re paying, consider a balance transfer. A balance transfer is like paying one credit card with another. You can sometimes get an introductory 0% APR offer for balance transfers, which could save you significant money on interest while you pay off debt.

If you’re planning on making a big purchase and know you’ll be carrying a balance, consider cards with a 0% introductory APR on purchases. You can avoid interest completely as long as you pay off the full balance before the 0% period runs out. Just keep in mind that if you have a high credit utilization rate, it could hurt your credit scores in the meantime.

The lowest regular APRs, including the longest 0% introductory offers, are usually only available to people with excellent credit. Most popular credit scoring models use a scale of 300 to 850 to indicate creditworthiness. Generally speaking, credit scores above 750 are considered excellent, while those below 600 are considered bad.

People with bad credit may have trouble qualifying for credit or getting a decent interest rate. However, a secured credit card could be a helpful way to start rebuilding credit if you find yourself in this situation.

Credit scoring models base your credit scores on several different factors, including:

  • Your payment history: Even one late payment can l affect your credit scores. The more recent or more severe the late payments on your credit reports become, the worse the impact on your credit scores will be.
  • Credit utilization: If all your credit cards are maxed out, your scores will almost certainly take a hit. Lenders like to see plenty of available credit on your credit card accounts.
  • Length of credit history: The longer you’ve had credit — and managed it wisely — the better your scores will generally be.
  • New credit inquiries: If you apply for a lot of new accounts in a short period of time lenders and credit scoring models may see it as a red flag that you could be desperate to borrow money. If you’re looking for a new card, choose just one or two companies to apply with to avoid too many inquiries on your credit reports.

If your credit scores are on the low side, you can take steps to improve them. One of the most actionable ways to potentially improve credit scores is to pay your credit card balances in full each month and keep your utilization low.

If you can’t pay your full credit card balance, make sure you pay at least the minimum due by the due date. Late payments are terrible for your credit scores and might increase your APR or cause your card issuer to close your account. If you’re 60 days late, your credit card issuer can charge a penalty interest rate on your entire balance. If this happens to you, don’t despair — it won’t last forever as long as you make on-time payments going forward.

If you have debt now or plan to carry a balance, but can’t get approved for a card with a 0% introductory offer, the next best option might be a card with a low interest rate on purchases, balance transfers, or both. One example is the Prime Platinum Visa from Lake Michigan Credit Union, with a very low APR on purchases, balance transfers, and even cash advances. If you’re a member of the military, you may have other options to reduce the interest rate on your card.

Now that you’ve read this article, do you understand the different APRs and what you can do to get the best interest rates? If not, just hit Ask at the top right corner of this page and we’ll get you the answers you need.

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At a glance

APR stands for annual percentage rate, which refers to the interest you’re being charged to borrow money. APRs can be calculated as simple or compound interest, and rates can be fixed or variable.

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