CardClub Education

Understanding APR

Interest Isn't Interesting... Until You're Paying Attention.

Content image — Credit cards are a special type of loan known for imposing heavy interest, in exchange for the freedom they provide. In order to compare cards, it's key to understand interest, APR, and how they relate.

Introduction:

If you have a predictable annual income, a personal budget, an emergency fund, and a good reason to borrow some money in the short term: you’re ready to start looking for a credit card. But, don't sign up just yet. There are a few more concepts you’ll need to grasp in order to shop effectively.

Since a credit card is a type of loan, the card’s interest rate should be a prime consideration in your decision. In order to make accurate comparisons between cards, you’ll have to understand the distinction between “interest” and “APR.” The terms are often used interchangeably, but it’s crucial to understand the difference before you start submitting applications. For now, we’ll keep everything conceptual without going too far into the actual mathematics.

Terminology:

An interest rate, in its simplest form, is the cost of borrowing money. When borrowing funds, you agree to repay the original amount (the principal) along with an additional amount, which represents the interest charged for the privilege and convenience of borrowing. “Interest” is merely the extra amount charged.

The Annual Percentage Rate (APR) is a special, standardized way of representing interest. It represents the total cost of borrowing, over the course of one year. It includes both the interest rate, as well as any fees associated with the card. It’s a comprehensive measure of the borrowing cost, providing borrowers with a clear picture of what they can expect to pay.

Credit cards operate on a monthly billing cycle, meaning any unpaid balance accrues interest on a monthly basis. To determine the monthly interest on any credit card, simply divide the APR by 12. For example, if a credit card has a 24% APR, the balance left unpaid at the end of the month automatically increases by 2%.

Significance:

While we strongly advocate for paying your entire credit card balance every month to avoid interest charges, we acknowledge that this may not be possible in every situation. If you anticipate carrying a balance from month to month, APR should be the most important factor in your decision-making process. A lower APR can save you money in interest payments over time, and some cards even offer an introductory 0% APR, giving you up to an entire year to pay off the balance.

Compounding Interest:

Credit card companies apply interest to outstanding balances, which can lead to substantial debt growth over time if not managed properly.

Compounding interest refers to the process by which interest is calculated on both the initial outstanding balance, as well as any previously-accrued interest. The larger your credit card balance, the more substantial the impact. If you carry a balance on your credit card and only make minimum payments, you'll find yourself in a vicious cycle where interest charges grow exponentially.

The APR on your credit card determines how quickly interest accrues. A higher APR results in faster debt accumulation. But, cards with relatively low interest rates can still hemorrhage debt if the balance is high enough.

Example: Compounding Interest

You have a credit card balance of $1,000 with an APR of 18%.

At the end of the first month, you'd accrue approximately $15 in interest, increasing your balance to $1,015.

In the second month, you'd accrue interest not only on the initial $1,000 but also on the additional $15 from the previous month. So this time, the extra charge is $15.23 — not $15.

This cycle continues each month, with interest calculated on the ever-growing balance, causing debt to spiral out-of-control.

Compounding interest with credit card debt can lead to a seemingly never-ending cycle of increasing balances if not managed effectively. By understanding how it works and implementing smart financial strategies, you can regain control of your finances and work towards becoming debt-free. Making consistent, timely payments and paying more than the minimum can significantly reduce the impact of compounding interest on your credit card debt, helping you achieve greater financial stability.

Factors Influencing APR:

Credit card companies often present the APR as a range, such as 14.99% to 24.99%. The specific APR you receive is influenced by a number factors, including your credit score and the current market's "prime rate."

The Prime Rate is simply the interest rate that banks offer to customers whose credit aligns with the Consumer Financial Protection Bureau's criteria for "good credit. That’s any score between 690 and 719. Cards with a "variable" rate are tied to the prime rate, and have an APR that rises and falls accordingly. Cards advertising a "fixed" rate do not adjust the APR in response to market interest rate fluctuations.

Conclusion:

With a comprehensive understanding of interest rates and APR, you're better equipped to navigate the world of credit cards. Knowing these concepts inside-and-out empowers you to choose a credit product that aligns with your goals and circumstances.