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What Is APR and What Does It Mean for Your Credit Cards?

Matthew Frankel, CFP, The Motley Fool

Your credit card’s interest charges are determined by your APR, but what exactly does that mean?

A pile of four different credit cards in various finishes.

Image source: Getty Images.

APR stands for annual percentage rate and tells you the cost of borrowing money on an annualized basis. While the terms APR and interest rate are often used interchangeably, they have substantially different meanings. With that in mind, here’s a primer on APR, how it differs from interest rate, how your credit card issuers determine your APR, how APR changes over time, and some smart ways to avoid credit card APRs.

APR vs. interest rate

When it comes to various types of loans, APR and interest rate can often be confused for one another -- understandably so, as they really are pretty similar.

Interest rate refers to the charge imposed by the lender, expressed on an annualized basis as a percentage of your debt’s outstanding balance. For example, if you owe someone $1,000 and they are charging you 10% interest, you’re paying an annualized rate of $100 per year to borrow money.

On the other hand, APR is a metric of the total cost of borrowing money, inclusive of any fees that must be paid to the lender. For example, if you obtain a mortgage at 4% interest and pay a $2,000 origination fee in order to get the loan, the actual cost of borrowing money is more than just 4% of the outstanding loan balance per year.

When it comes to credit cards, the terms are interchangeable. Even if your card charges an annual fee, it’s not really a cost associated with borrowing money. The only borrowing-related charge your credit card uses is interest, so in the case of your credit cards, the APR is the interest rate you’ll pay to borrow money.

How your credit card APR is determined

Credit card APRs vary considerably, but are generally determined by one or more of three main factors:

  • Your credit history. Many credit cards give borrowers with excellent credit scores lower APRs than those with so-so credit. For example, a particular credit card might offer APRs of 12.49%, 17.49%, and 21.49%, depending on the borrower’s credit.

  • The prime rate. The vast majority of credit card APRs are variable, and most depend on the U.S. prime rate. The prime rate is directly dependent on the federal funds rate, which is the interest rate controlled by the Federal Reserve, or Fed. If the Fed raises or lowers interest rates, you can expect your credit card’s interest rate to move accordingly.

  • The specific credit card and issuer. Many credit cards (especially store credit cards) offer a single APR to all borrowers, regardless of credit history. However, most still vary with the prime rate. To name a specific example, the Sam’s Club® Credit Card, issued by Synchrony Financial, calculates its APR as prime rate plus 19.65% for all cardholders.

How your APR is used to calculate your interest charge

Here’s where it gets a little more complicated. APR is an easy concept if the amount of money you owe stays constant day after day, and month after month. On the other hand, your credit card balance typically changes often.

Most credit card issuers use a method known as the “average daily balance” method to calculate interest charges. The issuer will first divide your APR by 365 to determine your daily periodic rate, and this will be multiplied by the number of days in the billing cycle to determine your monthly interest rate.

Then, the average balance of your credit card for each day of the month is determined and multiplied by your monthly interest rate.

Here’s a simplified example. Let’s say that your credit card has an APR of 18.99% and that this month’s billing cycle has 30 days. Dividing the APR by 365 and multiplying by 31 shows a monthly interest rate of 1.612%.

Now, let’s say that at the beginning of the month you had a $1,000 balance on the card, and 15 days into the month you made a $500 purchase, which is the only time you used the card during the month. That means your balance was $1,000 for the first 15 days and $1,500 for the other 15 days, giving you an average daily balance of $1,250.

Applying the 1.612% monthly interest rate to $1,250 shows a monthly interest charge of $20.15.

How credit card APR changes over time

I mentioned earlier that credit card APRs generally depend on the prime rate, so here’s a closer look at how this works.

The U.S. prime rate is determined by adding 3 percentage points to the federal funds target rate, which is the interest rate set by the Federal Reserve’s policy-making Federal Open Market Committee, or FOMC.

As of January 2019, the target range for the federal funds rate is 2.25%-2.50%. Adding 3 percentage points to the higher end of this range produces a prime rate of 5.5%. Therefore if your credit card’s APR is determined by adding 16.49% to the prime rate, you’d have an APR of 21.99%.

The FOMC typically raises or lowers the federal funds target rate in 25-basis-point (0.25%) increments. In our example, another rate hike would bring your credit card APR to 22.24%, and a rate cut would reduce your interest rate to 21.74%.

Avoiding credit card APR

One key point to notice -- credit card APRs are high. While you can find a mortgage or auto loan with an APR in the mid-single-digits, that’s simply not likely to be the case with credit cards. The average credit card APR in the U.S. is roughly 17.5%, and many people pay substantially more than that.

Fortunately, there are a few ways to avoid credit card APRs, aside from the obvious “don’t use credit cards.”

For starters, competition in the credit card industry is at an all-time high, so credit card issuers try to one-up each other with introductory offers. As a result, it’s possible to get a credit card that has a 0% APR for 18 months or longer. Some of the best 0% APR credit cards also allow you to earn rewards and have no annual fees.

If you have existing credit card debt, there are many credit card products on the market designed specifically for balance transfers. You can find 0% APR balance transfer offers for 18 months or more as well, and there are some balance transfer credit cards that don’t charge a fee (although about 3% of the transfer is standard).

Finally, if you’re looking for a more permanent solution, a personal loan can help lower your APR, give you a fixed monthly payment, and can help you to pay off your credit card debt in a specified amount of time.

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