Annual Percentage Rate (APR): What is it and Why it Matters
Annual Percentage Rates (APRs) were designed to help consumers compare credit cards. They can tell you whether one card will cost more than another and they are one of the most important components of a credit card.
Start lowering your credit card debt today.Call 800-422-6035.
But it’s not as straightforward as you might hope or expect. If you have ever been confused by the deceptive simplicity of credit card APR, this is the guide for you.
What is an Annual Percentage Rate?
In simple terms, an APR is the amount of money you will repay on a loan and it’s calculated against the value of that loan. If you take out a $10,000 loan at 10% APR, you can expect to pay $1,000 in interest, which means you’ll repay $11,000 in total.
But as any credit card user can attest, it’s never quite that straightforward.
The average credit card APR is 17%. This means that $10,000 of credit will generate an interest rate of $1,700, which means you’ll repay $11,700 in total. So, why are you paying so much money on your credit card and why does it escalate so quickly?
It’s all down to something known as compound interest, two words that should strike fear into the heart of every credit card user who has ever failed to clear their balance at the end of the month.
What is Compound Interest?
Compound interest essentially refers to the act of paying interest on top of interest.
Let’s go back to the original example and assume a debt of $10,000 and an APR of 10%. If interest compounds every year and you have a term of 5 years, your annual balance will look like this:
- $10,000 + 10% = $11,000
- + 10% = $12,100
- + 10% = $13,310
- + 10% = $14,641
- + 10% = $16,105
It looks a little less tempting now, doesn’t it? And this is essentially how credit card interest works, only it is compounded on a daily basis and often with a much higher interest rate. That’s why it seems to grow no matter how much you pay.
Why APR Matters
If the interest wasn’t compounded and was calculated as we discussed in the very first example, there wouldn’t be much difference between 19% and 20%. On a debt of $10,000, it would account for just $100.
If one company is offering you a host of perks and benefits for an APR just 1% higher, you could be forgiven for signing on the dotted line. That’s exactly what countless consumers do when they rush to join reward credit cards, even though doing so means paying a much higher APR.
As an example, some of the most popular store cards charge an APR of 26.99%, whereas the most popular credit card charges a maximum of 25.49%. That’s a difference of just 1.5%, which doesn’t seem like much at first glance. But if you repay $300 per month, which is just above the minimum, then the first example will cost you $6,717 in interest whereas the latter will cost you $6,052.
That’s a difference of $665, money that could be in your back pocket. Even if the store card returned 5% cash back on every dollar spent, it still wouldn’t cover the cost. And this is just one comparison. In fact, the 25.49% card we used as an example has rates that drop as low as 16.75% for some users and averages closer to 23%.
At 23% you’d pay just over $5,000 in interest, saving another $1,000, or $1,700 more than the 26.99% store card.
Do you Pay if You Clear Your Balance?
Interest is only charged if you don’t clear your balance every month. If you do, then you shouldn’t be charged the quoted APR. However, you may still have annual fees and other charges to pay and there are also cash fees to consider.
Cash fees are charged every time you make a cash withdrawal, use your card to buy lottery tickets or gamble in a casino, or use it to purchase foreign currency. You will be charged a fixed APR, often higher than the payment APR, and may also be hit with additional usage fees. This is why you should never use your credit card to withdraw cash or gamble.
It’s also worth noting that your total interest charges will be much lower if you regularly load and unload your credit card. For example, if you get a credit card on day 1, max it out in the first week, and then never use it again, you’ll be hit with the maximum charges and will spend a long-time repaying interest.
If, however, you max it out in the first week, repay half in the second week, and then get stuck in a cycle of repaying large amounts and spending large amounts, you’ll pay much less because the compound interest isn’t always drawing on a maximum balance.
This is why you should repay as much as you can whenever you can. It may seem like throwing good money after bad, but in the long-term, it can save you a lot of money.
How to Avoid High APR Charges
If you have a good credit history and a high credit score, then you’re in a very strong position and shouldn’t settle for high APRs and high fees. By all means, get a rewards card, but only if you’re 100% confident that you can clear your balance every month.
If you’re not confident of clearing your balance or have no intention to do so, your only focus should be the APR. You may need to apply for a few cards and run a few soft and hard inquiries but providing this all takes place within a 14-day to 45-day period then it will be classed as “rate shopping” and will count as a single hard inquiry.
If you apply for a card that promises an extensive range, only to offer you the highest APR when you go through the application process, don’t be scared to refuse it and move on. There are many other providers out there and many other opportunities. If your credit history is solid and your score is high, you don’t need to settle for the first offer.
Summary: Every Digit Counts
Interest rates are behind every debt that you have, and APRs are at the heart of every credit card debt. It’s important to understand how these work, and hopefully you’ll now have a firm grasp of what they mean and how they affect you.
We have a complete section dedicated to credit card debt that can help you with this issue. We also have a number of calculators, tools, and resources to help you escape the clutches of this escalating, seemingly never-ending debt. So, if you need a little more advice and tips, be sure to give them a read.