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how APR works
24 May 2019

The Ultimate Guide to How APR Works

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Debt gets a bad rep. When you receive a shiny new credit card in the mail, it’s easy to feel you’ve just received a gift from a friend. It’s this misunderstanding though that leads to trouble.

Creditors and lenders need to make money from the credit they extend to you. Understanding the basics of how APR works is a great step towards empowering yourself financially.

Though more than 78 percent of Americans have credit cards, the term APR isn’t a common topic of conversation.  Check out this guide to how APR works to gain insight on how to get out of debt quickly using as little of your own money as possible.

What is APR?

An APR is an acronym standing for annual percentage rate, that is used when referring to fees paid for everything from personal loans to mortgages to credit cards. APR includes both the interest rate and standard financing also known as the standard cost of the loan.

Additional one-time financing fees that are not regularly charged, such as balance transfer fees on a credit card, are not included in your APR. The fees APR includes varies from lender to lender.

Some lenders include only an interest rate in the APR while others include a variety of fees. The terms provided with your loan or credit account detail the way your fees are applied.

Learning about interest rates is a great way to deepen your understanding of APRs.

What is an interest rate?

An interest rate is a percentage applied to an amount borrowed. The percentage is added to the full balance of the loan at various time intervals depending on the kind of interest rate.

When a borrower agrees to the loan terms, they agree to the amount borrowed plus the cost of interest. Sometimes this means the loan amount might double or triple depending on the length of the repayment term.

Interest rates are basically what the lender or creditor charges to borrow its money. For an investor, an interest rate is a total amount received for keeping money in a certain account or investment product.

There are two common types of interest rates you need to know:

  1. Annual interest rate applies to the percentage interest applied over a one-year period. It can be calculated as your APR minus standard fees.
  2. Periodic interest rate is the percentage charged during one billing cycle. This is the rate you can use when calculating monthly interest charges.

Here’s an example of how periodic interest rates work. Take the current balance of a loan or credit card and multiply it by the periodic interest rate. The result is the accrued monthly interest charges.

Each month, the accrued monthly interest charges deduct from your monthly payment. This means only part of your monthly payments actually applies to the amount borrowed or charged. The full amount borrowed is called the principal amount.

How Debt Grows

It’s important to know how your loan balance grows using an interest rate. The interest rate is a major component of your APR and can easily cause you to fall behind on your payments when you’re not sure how to calculate how much of your payment applies to the principal amount.

For example, if you have a mortgage for $240,000 at 5% interest, the bill each month will be $1,288.37. Only $288.37 goes toward the $240,000 you originally borrowed. The remaining thousand dollars is the lender’s profit in interest charges.

Lower interest rates are usually offered to the most creditworthy borrowers. Strong credit history and long-standing credit card accounts are two ways to get access to the best interest rates.

High-risk bad credit borrowers are generally asked to pay higher interest rates. High-risk borrowers include anyone with no credit history or poor creditworthiness. The borrower is considered high risk because the lender is unsure of whether the debt will be repaid.

A borrower with little experience handling debt might then have trouble managing additional fees added to a balance over multiple billing cycles.  This creates a troublesome cycle where newer, uneducated borrowers end up remaining high-risk over an extended period of time.

What Factors Affect Interest Rates?

Though creditworthiness is one of the top factors affecting interest rates, there are other strong influences that can drive interest rates up and down. The economy is one outside influence that impacts interest rates.

When inflation is high, for example, there is a higher demand for credit. Inflation means the amount of cash in circulation is low. Interest rates are more likely to rise during inflation which creates a cyclical problem.

High-interest rates can make loans unaffordable for many without the case to repay the debt.  When a high number of borrowers are unable to repay their debts, the economy worsens.

Which Fees Does APR Include?

Beyond interest rates, APR includes a number of other finance charges. Here are a few standard fees that might be included in an APR:

  • Administration fees
  • Processing fees
  • Fees paid to an underwriter
  • Fees for document preparation

On a mortgage loan, APRs include a much longer list of fees. Here are a few examples:

  • Points
  • Prepaid interest
  • Fees paid to brokers
  • Private mortgage insurance (PMI)
  • Escrow fees
  • Closing costs

For credit cards, there are no miscellaneous fees included with the APR. The term annual interest rate and annual percentage rate are interchangeable with a credit card.

Types of Credit Card APRs

The term annual interest rate can be confusing. There isn’t a credit card that holds off on charging you interest until the end of the year. Most cards compound interest daily.

The way interest gets applied depends on the type of charge and how you pay off the balance. When you receive a new credit card in the mail, disclosure statements are included that explain when and how annual percentage rates apply to your account.

The main types of APRs for a credit card account are purchase, balance transfer, penalty, and cash advance APRs.

These interest rates are divided because they require different types of transactions in order for you to access the funds. Here’s a quick overview of each APR type:

Purchase APR. Anytime you buy anything using your credit card, a purchase APR is applied. This is, by far, the easiest transaction to understand because it is the most common way to use a credit card. When we think of credit card interest rates, we usually think of purchase APR.

Balance Transfer APR. A new credit card offer often lures you into a balance transfer with the promise of an introductory APR of as little as 0 percent for a fixed period of time. When you move the balance, however, the transaction itself isn’t free. There is a small one-time fee called a balance transfer APR that applies to the amount of money being transferred. Balance transfer APRs are usually small but can be larger than the purchase APR in some rare cases.

Penalty APR. The penalty APR is when credit card companies profit the most. When your account is delinquent, a rush of fees hit your account sometimes making your balance skyrocket. Your account is usually considered delinquent after 60 days of nonpayment. Penalty APRs are pretty high with the average set at 29.9 percent. This rate is also the legal maximum for a penalty APR.

Cash Advance APR. If you use your credit card to get funds (via an ATM withdrawal, etc.), you will be charged this rate of interest – separate from all the others. This is usually not as high as the Penalty APR, but tends to be greater than purchase/balance transfer APRs. What makes cash advance APR a dangerous foe is that it does not come with a grace period. That is, you start getting charged the cash advance interest the day you take it out. We explain what a “grace period” is in the section below.

Managing Your Grace Period

Credit card companies give incentives for balances repaid within a billing cycle. This time frame is often referred to as your APR grace period.

The benefit of paying off your statement balance within the grace period is the opportunity to avoid paying any interest. Your statement balance is the amount shown on your bill that reflects the total amount that you owe on the credit card up to the end of your most recent billing cycle.

Always take advantage of this option to avoid interest. It can save you hundreds, sometimes thousands, of dollars each year given that credit card interest is compounded daily.

The average length of your grace period is 25 days. Your credit card statement will generally separate your balances so you can see which amount is the full balance and which is considered the statement balance.

What is an Average Credit Card APR?

Credit card APRs come in all shapes and sizes. The one assigned to your card is based on your creditworthiness.

Different card brands and issuers offer promotions to attract new cardholders so expect your APR offers to fluctuate. Rewards credit cards are known to have higher APRs to balance out the incentives.

In 2019, the average credit card APR for a general card is approximately 17 percent. Airline and student credit cards offer higher APRs at an average rate of 18 percent.

How APR Works: Calculating Your Charges

The way APR applies to your monthly credit card bill is not obvious. You can’t simply calculate the percentage using your most current balance.

The complication comes with the fact that your balance fluctuates each month. In addition, other types of APR might apply during the billing period making the math difficult to work through.

Use the following examples to learn how to calculate your exact APR each month:

Total Credit Card Interest (Each Month) = Balance x Daily Periodic Rate x Number of Days in Billing Cycle

There is no APR in this formula. Or is there? When calculating your interest, credit card companies use what’s called the Daily Periodic Rate (DPR).

It’s not a bait and switch, but instead, a viable way for a creditor to track what you spend each day. For this reason, interest is always accumulated daily even though you have an APR.

The APR is the annual periodic rate. To get your daily periodic rate, divide your APR by 365 to reflect the number of days in the year.

This changes the formula above to the following equation:

Total Credit Card Interest (Each Month) = Balance x (APR / 365) x Number of Days in Billing Cycle

The number of days in a billing cycle obviously changes from month to month, but it’s basically the number of days between bills.

How to Lower Your Credit Card APR

Carrying a balance on your credit card is the number one way to drive up your debt. Still, you have options to avoid paying high interest rates each month.

Use introductory card offers to your advantage. When you receive a new card offer in the mail with a 0 percent introductory APR, take advantage of it by doing a balance transfer. Transferring your balance is rarely more expensive than carrying a large debt on a card over time.

Some cards offer an “introductory” rate that can last as long as 21 months. This gives you a chance to focus on paying down the principal with no penalties.

Don’t transfer a balance to a card you plan to use immediately for purchases. Some cards require you to pay off the transferred balance before you can enjoy the 0 percent APR on new purchases.


Sometimes your APR is raised when your account falls behind. You can reduce the APR by making the minimum required payment each month. Expect to wait for several billing cycles before your APR is restored to its original amount.

The on-time payments improve your credit score and give the creditor a new track record to use when determining whether you are worthy of a lower rate. This does not always happen automatically.

Plan to submit a formal request asking that your APR be lowered based on your recent payment history.

The Depths of Debt

Debt can be a huge relief when making business investments or large lifestyle purchases. On credit cards, the trick to making your debt more manageable is to understand how APR works and use the loopholes to your advantage.

Always pay your debt in full before the end of the billing cycle. Spending $10 on a movie ticket is innocent until a $1.70 surcharge is added to each ticket when you carry a balance. In this case, each item becomes overpriced and not worth the credit card transaction.

To learn more about APR, installment loans, or anything about managing your personal finance, visit our website. Here are some other articles you might find helpful:

9 tips for getting overdraft fees waived
How to manage your installment loan debt
Understanding when you should take out a loan to pay off credit card debt
Safeguard your finances with these 7 credit card safety tips