When it comes to managing your credit health, understanding how credit cards work is important. Credit cards are a popular credit product for consumers. According to TransUnion’s latest Consumer Pulse Study, of those who plan to apply for new credit or refinance in the next year, over half are planning to apply for a credit card.
One aspect of credit cards that you may have heard of is APR. You may know your interest rate and know that if you carry a balance, you could be charged interest. But do you know what APR really is and how it impacts your balance? Below we break down the basics of APR.
What is APR?
APR stands for Annual Percentage Rate. APR is reflected as an annual rate you’ll pay on an outstanding balance you carry on your credit card. Unless you have a special or promotional interest rate, you’ll likely be charged interest each month until you pay off your balance in full.
One important factor that determines the APR of your credit card is your credit score. People with higher credit scores are generally considered less risky borrowers and may qualify for lower interest rates. Credit cards aren’t the only loans that have APRs. Though, credit cards are short-term loans and tend to have higher APRs than longer-term loans like mortgages, auto loans and personal loans.
What is APR on credit cards?
The actual amount of interest you’ll be charged on your outstanding balance is based on your APR. What can be confusing is that APR is annual, but you’re charged on a monthly basis. And to complicate it further, even though you’re charged on a monthly basis, your interest charge depends on your average daily balances. Banks use similar, but sometimes slightly different formulas to determine your daily interest percentage rate.
How to calculate APR on credit cards
Your APR is predetermined and listed in your cardmember agreement. You can typically find your cardmember agreement in the documents section in your account online. It should also be included with the documents when you receive your card for the first time. If you have questions or are having trouble finding it, contact your lender directly.
Now, when people talk about calculating APR, what they’re usually trying to determine is how to calculate the interest charges for their balances each month. Here’s a basic way to calculate interest charges using your APR:
First, calculate what’s called your daily periodic rate (DPR). Remember, APR is based on an annual basis, but many card issuers charge interest on daily balances. To find your DPR, you take your card’s APR and divide it by 365, the number of days in the year.
To calculate the amount of interest you’ll be charged in a given month, you would multiply your DPR by the number of days in the billing cycle, and then multiply that figure by your average daily balance.
Here’s an example:
APR = 24%
Average daily balance = $2,500
DPR = 24%/365 days = 0.0658%
Interest charge = $2,500 x 0.0658% (0.000658) x 30 days = $49.35
Keep in mind this is a general way of calculating interest and isn’t meant to be exact. You may have different categories of transactions or purchases that have different interest rates, like cash advances, for instance. These varied rates can affect your total interest charges. Your cardmember agreement will tell you how interest is calculated for your credit card purchases and should give you a similar example to the one above.
Can your credit card APR go up?
Your APR can change under some conditions. Credit card APR is usually variable, so it can go up or down. Generally, lenders are not allowed to raise your interest rate on credit cards for the first year. After that first year, your card issuer needs to give you 45 days of notice before your new APR takes effect for new purchases.
Here are some instances in which your rate could change:
A change in the prime rate
Part of your credit card APR is based on what’s called the prime rate. The prime rate is an index rate, which is based on the Federal Reserve’s federal funds rate. Mortgages and auto loans tend to be fixed rate loans, with interest rates that don’t change. But credit cards are loans that usually have a variable rate, which can change as market conditions, like adjustments in the prime rate, change. So if interest rates go up, so could the APR for your credit card account.
You miss a payment
Your credit card issuer can increase your APR if you’re more than 60 days past due on a minimum payment. Making only the minimum payment on a card isn’t a fast way to get out of debt, but it keeps your account current and helps you avoid any late payment fees. A missed payment can have a significant impact on your credit score too, not just your APR.
You had a temporary or introductory rate
Some card applications offer an introductory or teaser rate when signing up. Promotional, temporary 0% APR for new purchases or 0% APR on balance transfers are a popular marketing offer for credit cards. After these promotional rates expire, your APR will likely be raised to the rate outlined in your cardmember agreement. Make sure you understand all the terms of any promotional offers you’re considering. Also, balance transfers may offer 0% APR for a set period of time, but may come with a fee depending on the amount of money transferred to the new card.
Managing your credit card
Credit cards can be an effective tool for building credit. But if you don’t know how to manage your credit cards, it can lead to debt with high interest charges. In order to use credit cards to build credit while maintaining healthy finances, you’ll want to pay off all your balances each month. If you pay your balances in full each month, you can avoid interest charges. This will mean you have a steady, positive payment history and your credit utilization is low, which are important credit score factors.
If you’re getting started and want to learn more tips for healthy credit, read our blog How to Build Credit.