Three little letters can significantly influence your finances: A…P…R. This often misunderstood acronym stands for “Annual Percentage Rate” and represents the cost of borrowing money.
Generally, the higher the APR, the more you can expect to pay in interest. Understanding how APR is determined; the differences between the different types of APRs, and how APR is used to calculate interest, could help you determine which credit card is a good fit for you.
How Credit Card APR Is Determined
Credit card issuers determine your annual percentage rate upon credit approval. Many creditors start with a financial index, or benchmark, such as the U.S. Prime Rate or LIBOR, and add several percentage points (the margin) to set the actual rate. The margin is typically assigned based on the applicant's creditworthiness, reflected by the applicant’s credit score and other financial information the creditor uses for approval. For example, if the U.S. Prime Rate is 5.5%, the credit card issuer might add a margin of 10 percentage points for applicants with good credit, while those with poor credit might get a margin of 24 percentage points for the following APRs:
- Good Credit APR: 5.5% + 10% = 15.5% APR
- Poor Credit APR: 5.5% + 24% = 29.25% APR
Three Types of APRs
The three most common types of credit card APRs are fixed, variable, and promotional.
A fixed-rate APR is established during credit card issuance. It’s not expected to change, but could under certain circumstances, as described in the cardholder agreement—the contract between you and your credit card issuer. Creditors must provide card members advance notice of any changes to a fixed-rate APR.
A variable-rate APR is also established during credit card issuance. It fluctuates with changes to the financial index. So, if the U.S. Prime Rate increases by, say, one percent, you can expect that the variable-rate APR on your credit card will increase accordingly. Creditors need not provide advance notice of variable interest rate changes. It’s up to you to pay attention to your billing statements to stay on top of any changes.
A promotional APR is offered upon credit card issuance or on specific types of transactions, such as balance transfers. In either case, the APR is valid for a limited amount of time. For example, a credit card may offer a six-month 0% introductory APR to new cardholders or a 0% APR on balance transfers up to a set dollar amount.
It’s expected that a promotional APR will convert to a fixed or variable-rate after the promotional period ends. It would be unusual, however, for a fixed-rate credit card to convert to a variable-rate card or vice versa. Your cardholder agreement will confirm WHICH type of APR is being used for your specific credit card.
It’s worth mentioning that a different APR may apply to purchases, cash advances, and balance transfers, even when using the same credit card. If this is the case, it should also be specified in your cardholder agreement.
How Credit Card APR Affects Your Balance
APR calculations vary by creditor. Your cardholder agreement will detail how your rate is determined and how it is applied to determine your credit card balance.
Credit card issuers may choose to provide card members with a grace period before applying APR charges to the account. If yours does so, you can avoid paying any interest on your purchases if you pay the entire statement balance in full by the due date.
If, however, you pay less than the total statement balance, the assigned APR will be used to calculate the interest added to your credit card balance. These interest charges will appear on the next credit card statement along with any other transactions that occurred through the statement closing date or last day of the billing cycle.
How Credit Card APR is Used to Calculate Interest
Although it has “annual” in the name, “annual percentage rate” does not mean the interest rate that you pay once a year, because you don’t just pay interest once a year. Annual percentage rate is significant because it is used to determine your “daily interest rate,” which is what is used to calculate your interest payments.
For illustrative purposes, let’s take a $1,000 balance and 20% APR scenario. We would divide 20% by 365 (the number of days in a year) to convert this APR into a daily interest rate:
Daily Interest Rate = 0.0548%
The amount of interest you pay each billing statement is determined by this daily interest rate. This rate is multiplied by your average daily balance. Average daily balance is used because, if you’re making purchases or payments during the billing cycle, the balance will change throughout the cycle. The way credit card companies calculate your average daily balance is by taking your account balance at the end of each day of the billing cycle, adding them all together, and then dividing that sum by the number of days in your billing cycle.
So, let’s say that your balance was $1,000 for the first 15 days of your 30-day billing cycle, but then you made a purchase of $100 on Day 16 and made a payment of $200 on Day 25. You average daily balance would be:
$1,000 X 15 days = $15,000
$1,100 X 9 (Day 16 - Day 24) = $9,900
$900 X 6 (Day 25 - Day 30) = $5,400
TOTAL = $30,300
Divide this total by 30, the number of days in the billing cycle to get an average daily balance of:
$30,300 ÷ 30 = $1,010 Average Daily Balance
Then multiply the average daily balance by the daily interest rate:
0.0548% of $1,010 = $0.55 in Interest per Day
And, finally, multiply what you’re paying in interest each day by the number of days in the billing cycle.
$0.55 X 30 = $16.60 in Interest that Month*
*If interest is compounded daily instead of monthly, interest paid that month will be slightly higher.
While APR is an important factor when selecting a credit card, your financial lifestyle should guide your decision on which credit card is right for you. Examine your credit card usage. Do you use a card instead of cash for everyday purchases and pay the balance in full each month? If so, then your preference might be a higher-APR rewards card that offers benefits a lower-interest-rate credit card doesn’t offer. On the other hand, if you tend to carry a balance from month to month, then a credit card offering a lower APR might make sense.
Ready to find a credit card with an APR that fits your lifestyle? See if you Pre-Qualify for a Credit One Bank credit card in less than a minute—without harming your credit score.
Tracy Scott is a freelance writer who specializes in personal finance and higher education. As a contributor for Credit One Bank, she has combined her expertise in these two areas and managing credit to create informative, engaging content for readers. Her reading list always includes a seemingly odd mix of financial literacy articles and sweet romance novels. She holds a BA in Psychology from the University of Texas at Austin and has a background in higher education regulatory compliance.
