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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 is APR? The annual percentage rate is what your lender charges you to borrow money — it’s the “price” of your loan.
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. 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 $4,000 in interest charges. The actual price, or cost, of the loan is $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, and your APR will have no effect on the cost of borrowing money.
What’s the Difference Between Simple and Compound Interest?
Interest charges are calculated as either simple interest or compound interest, and it matters a great deal which type your lender or credit card issuer applies to your loan.
Most personal loans, such as auto loans and student loans, are simple interest loans. When you make your payment each month, the interest is paid in full and the balance of your payment reduces the principal balance. If you make your monthly payment early, your interest charges are lower and more of the payment goes toward your principal.
With compound interest, interest charges are calculated on both the outstanding balance, including new purchases, 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, which means 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 interest once per year, you’d pay about $200 in interest ($1,000 x 0.20 = $200).
But with most credit cards, interest is usually compounded on a daily basis. The issuer calculates your average daily balance and multiplies it by your daily periodic rate (your APR expressed as a daily value: APR ÷ 365), and then adds those interest fees to your outstanding balance.
In effect, if you don’t pay your credit card balance in full each month, the “interest on interest” fees 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. This is because card issuers usually offer a grace period, in which interest won’t be charged on purchases as long as you pay off those purchases in full.
What Is a Variable APR Loan or Credit Card?
Just as simple versus compound interest affects your annual percentage rate and the true cost of borrowing money, fixed versus variable APR plays another important role.
As you’d guess, 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 are attractive because they often come with low introductory rate APRs.
Variable APR works like this: Your bank or credit card company pegs the annual interest rate to a financial index and adds a fixed amount, known as a margin, to determine your APR. Most variable-rate loans are pegged to the U.S. prime rate, which is the lowest APR banks charge their most credit-worthy customers, although other indices, such as the LIBOR (London Interbank Offered Rate), are sometimes used.
The average margin for variable APR credit cards is around 14 percent. If the U.S. prime rate is 4.5 percent, and your credit issuer charged the average margin, your interest rate would be 18.5 percent (index rate of 4.5% + 14% margin). Depending on the lender, 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: The most common type of APR that you’ll see. This is 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 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: There are credit cards designed for balance transfers that have 0% intro APR rates on balances you transfer over. Usually you need to complete the transfer within a few months after getting your new card.
- Cash advance APR: Most issuers charge a higher APR on cash you borrow on your card than on your regular purchases. You’ll also 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 about 29.99 percent, and there is currently no law limiting the penalty rate banks can charge.
Something to 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. 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, which is like paying one credit card with another card. 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.
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 getting any type of credit; they’ll usually pay exorbitant interest rates if they do find a lender.
Credit scoring models base your credit scores on several different factors:
- Your payment history: Even one late payment will affect your credit scores. Some scoring models treat all late payments the same, while most will penalize you more for recent late payments compared to those that happened a year or two ago.
- Credit utilization: If all your credit cards are maxed out, your scores will take a hit. Lenders like to see plenty of available credit on your loans and credit lines.
- Length of credit history: The longer you’ve had credit — and managed it wisely — the better your scores will be.
- New credit inquiries: Lenders see lots of credit report inquiries in a short period of time as a red flag that you may 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 report.
If your credit scores are on the low side, you can take steps to improve them. Your best bet is to pay your balance in full each month to help keep your utilization low.
If you can’t, make sure you’re at least paying the minimum due by the due date. Late payments are terrible for your credit scores, and may affect your APR more than you realize. If you are 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 shouldn’t last forever.
Under the Credit Card Accountability, Responsibility and Disclosure Act of 2009, or CARD Act, lenders must reduce your APR to the normal rate after you’ve made your payments on time for six consecutive months.
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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