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What is APR on a credit card, and how does it work?

Photo illustration of three credit cards with percentage symbols and dollar signs creating an upward diagonal line from left to right.
You can avoid getting charged the APR by paying your balance in full and on time by the due date every month.
Photo illustration by Fortune; Original photo by Getty Images

Two people might apply for credit cards from the same bank and receive identical-looking cards in the mail. But the prices they pay to use those cards will be completely different if they have different APRs. To understand how much a credit card costs and compare it to other cards, you have to dig into the details of how APR works.

What is a credit card interest rate? 

A credit card interest rate is the price financial institutions charge for lending you money. 

When you buy something with a credit card, you’re borrowing money from the bank that issued the card. The bank pays the merchant for your purchase upfront. Later, the bank sends you a statement detailing how you used the card and how much you owe, and that’s when you pay the bank back. The interest rate is the price you pay for using the card if you don’t pay the full balance by your statement due date.

Financial institutions charge interest on credit cards because that’s one of the many ways they make money. Another reason interest is charged is to manage the risk of a borrower not paying back anything they borrow on their card. During the application process, a credit card issuer will assess the likelihood of a borrower being unable to repay their balance (i.e., the credit risk) during the application process. This will influence the potential revenue expected from any balances charged to the card and, as a result, the lending rate it charges the cardholder.

Banks charge interest as a percentage rate so that the more a cardholder borrows and carries on their card, the more they pay. Someone who doesn’t use their card much or simply pays off the entire balance each month won’t owe any interest. “The interest is really necessary to make sure that they’re charging the people that actually borrow money and not the people who don’t,” says David Shipper, strategic advisor in the Retail Banking & Payments practice in Aite-Novarica, a consulting firm that works with financial institutions.

Banks charge different APRs to different cardholders, with the lower APRs going to cardholders the bank considers to be more reliable borrowers. 

“Essentially a bank has been forced to try to figure out, ‘Is this person going to pay us back or not?'” says Rachel Ehrlich, COO of Klutch. “A credit score was created to help banks with exactly that.” Banks use your credit score plus factors like your income and location to estimate your credit risk. Some banks may also consider how much you’ve deposited in savings or investment accounts with them.

How APR works

The APR on a credit card is the interest rate expressed as the rate for a year. Stating the interest rate in this standardized way allows consumers to easily compare rates between different cards. By law, credit card issuers must give you a disclosure that shows the APR when you apply for or open a credit card, and they must display the APR in account statements. 

Banks don’t charge credit card interest on an annual basis. Instead, they generally apply a daily periodic interest rate, which is the APR divided by either 360 or 365 days, depending on the formula they use.

Banks typically offer a grace period, which is a length of time after making a credit card purchase when you don’t have to pay interest. The grace period lasts until your monthly payment is due, which must be at least 21 days after the bank sends you the account statement. If you pay off your entire balance by the due date, the bank doesn’t charge interest on your purchases.

If you don’t pay the whole balance by that date, you lose the grace period and the bank starts charging interest on your outstanding balance. Now, any new purchases you make begin accruing interest immediately. 

You may be able to get the grace period back by paying your balance in full each month. The bank likely won’t restore the grace period until you pay the entire balance for two months in a row.

To figure out the interest you owe, the bank typically multiplies your balance on the first day of the billing cycle by the daily periodic rate to calculate the interest for that day. Then, it adds the interest to your balance for the next day. It repeats the process for each day in your billing cycle. Adding up the interest for each day gives the total interest you owe for the billing period, which appears on your statement. 

When banks use this method to calculate interest, the interest you owe compounds daily. This means that you’re charged interest not just on the amount you borrowed, but also on interest from previous days that you haven’t paid off yet. The result is that if you carry a balance for an entire year, the percentage of your balance that you pay in interest will be higher than the stated APR because the APR figure doesn’t take into account how often interest compounds.

What is a good APR for a credit card?

The best credit card rate possible is the prime rate, which is the rate banks pay to borrow money from each other overnight. Banks set this rate based on the federal funds rate. A bank that greatly values your business may pass on this rate to you without a markup. “That’s the rate for the most creditworthy, biggest customers the bank has,” says Herman “Tommy” Thompson, Jr., certified financial planner and Financial Planner at Innovative Financial Group.

For everyone else, banks charge an APR that equals the prime rate plus a margin.

Banks offer most people who are approved for credit cards APRs over 20%, so an APR below 15% is a favorable rate in comparison. But even a good credit card APR is typically higher than the rates banks charge on other borrowing methods. “Credit cards are generally just destructive rates,” Thompson says. “If you have decent credit, the bank will do a loan either secured by an asset you have, or even just a signature loan for usually less than half of what you’ll pay on a credit card.”

How to avoid paying APR

You can avoid getting charged the APR by paying your balance in full and on time by the due date every month. If you aren’t able to do that, you could try to find a different card with a 0% APR on balance transfers. Transferring your balance could give you more time to pay it off before the APR kicks in, but keep in mind that you’ll typically owe a balance transfer fee of 3% to 5%.

Another option is to get a debt consolidation loan with a lower APR and use it to pay off your balance, but again, fees will generally apply.

If you’re carrying a balance on your card, making payments more frequently than once a month can reduce the interest you’re charged. “You can actually pay your credit card any day you want, there’s no one day that you have to do it,” Ehrlich says. “The more you pay down your balance, the less interest you pay.”

Before you open a credit card account, pay attention to the APR and consider whether you can afford it.

“A lot of people think they’ll never have to pay their interest rate, so they don’t worry about it,” Ehrlich says. “But it’s a really important factor. So I would never ignore that or be overly confident, because the majority of people do have to pay an interest rate at some point during the life of the credit card.”

Fixed vs. variable APR

A credit card APR can be “fixed,” meaning that it doesn’t go up and down with the bank’s borrowing costs—at least not for a set period of time. Your bank can change this rate if it gives you 45 days’ notice.

Most credit card APRs are variable. They fluctuate with the prime rate, and the bank doesn’t have to give you a heads up that the rate is changing. Your account statement will note if there have been any changes to your variable rate. It will also tell you the upper and lower limits on your APR.

What are the different types of credit card APRs? 

Generally, credit cards come with a few APRs that apply in different situations.

  • Purchase APR: This is the rate that ordinarily applies when you use the card for everyday purchases. “It’s the main one that’s listed,” Ehrlich says.
  • Cash advance APR: This APR is charged when you write a check from your credit card account or use your card to draw cash from an ATM. “Usually a cash advance would be a higher APR because it’s a riskier thing for a bank or a credit card company to do,” Ehrlich says.
  • Introductory APR: Banks commonly offer 0% purchase or balance transfer APRs for the first year or two after you’re approved for a new card. “It’s really to entice you to use the card and open the account,” Shipper says. After that, you’re charged the regular purchase APR that you were approved for based on your credit.
  • Balance transfer APR: Banks also charge APRs specifically for balance transfers. This is a promotional rate that applies for a limited time to the balance you’ve moved to the card. .
  • Penalty APR: Missing a payment, making less than the minimum payment, or exceeding your credit limit can trigger a penalty APR, which is usually the highest APR the bank can apply on your card. This APR is meant to incentivize you to pay the past due balance promptly and to offset the risk that you might default on the account.

How to calculate credit card APR

To understand how the APR is applied to a credit card balance, it may help to look at an example. 

To get started, you need to find the daily periodic rate for your card, which is the APR divided by either 365 or 360, depending on your bank’s method. Your cardmember agreement will show how the bank calculates the daily periodic rate and will tell you what the rate is.

For this example, let’s say your APR is 25% and your bank divides that rate by 365 days.

Then your daily periodic rate is 0.25365 = 0.00068.

So, you have a daily periodic rate of 0.068%.

Next, calculate the average daily balance for the billing cycle. To keep things simple, we’ll assume there is no grace period.

Let’s say you begin the month with a balance of $800, and you have that balance for 10 days. Then, suppose you charge another $400 on your card, so your balance goes up to $1,200. Your balance stays at that level for another 10 days. Next, you make a $200 payment and your balance goes down to $1,000. Your balance stays there for the next 10 days.

To find the average daily balance, add up the balances and divide by the number of days in the billing cycle. Here, that’s $800 x 10 + $1,200 x 10 + $1,000 x 10 / 30 = $1,000.

So your average daily balance is $1,000.

Next, use this formula to find the interest you owe for the month:

Interest = Daily periodic rate x Average daily balance x the number of days in billing cycle

That’s 0.00068 x $1,000 x 30 = $20.40.

In this example, you owe $20.40 in interest for the month.

If multiple APRs apply, like if you charge purchases to your card and also take out a cash advance, the bank would calculate the interest on each type of balance separately.

Keep in mind that this is a simplified example. Banks often compound credit card interest daily, so that the interest on one day’s balance gets added to the balance of the next day. That makes the actual math banks use more complicated.

Our math gives a good approximation of the interest over a month, but it will be less accurate over a longer period as the compounding adds up.

The takeaway 

Credit cards offer convenience, but they’re not free. Your card’s APR is the price the bank sets for carrying a balance. Before you charge anything to a credit card, make sure you’re aware of the APR. And ideally, you should pay off your whole balance by the due date so you won’t owe interest.

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