You stare at your credit card statement and sigh at the amount you owe this month. Recent statistics show the average balance an individual carries on their credit card hovers around $5,897. You desperately want to control your mounting credit card debt, but every month, the balance grows exponentially.
Glancing at the fine print, you see abbreviations and associated numbers, but don’t necessarily understand what this means for your bottom line. The words annual percentage rate (APR) appear all over your credit card statement as well as several mentions of interest rates. What do APR and interest rate mean? And does understanding these terms make a difference in how you handle your finances? The short answer is yes.
Check out this guide on the ins and outs of APR and interest rates, and how to lower both.
Is there a difference between APR and interest rate?
There is no difference between APR and interest rates for credit cards. The APR is the yearly rate to borrow money, while the interest rate refers to the daily charge applied to the balance based on the APR.
“Because interest is accrued on a day-to-day basis for a credit card, the terms APR and interest rate are often used interchangeably,” said Jim Pendergast, senior vice president of The Southern Bank Company in Alabama.
How do credit card APRs work?
A credit card APR compounds daily. “This means you are paying interest on your outstanding balance every single day you maintain a balance,” said Adem Selita, CEO and co-founder of The Debt Relief Company.
APR is dependent on an individual’s timeliness of payment and credit score. Consumers must be proactive in learning about how APR is calculated.
“Most credit cards charge variable rates—meaning they can fluctuate up and down in line with an index such as the prime rate,” said Ted Rossman, senior industry analyst for Bankrate.com and Creditcards.com. The prime rate—what banks typically charge their customers—is 3.25 percent.
The APR is usually calculated by adding the prime rate plus the card issuer’s profit margin. It is often represented as the prime rate plus, say, 15 percent (which reflects the card issuer’s profit margin). Rossman explains that the APR would be 18.25 percent in this case.
“When the Federal Reserve adjusts the federal funds rate, the prime rate moves in tandem. So it’s fair to say that the Federal Reserve plays a key role in setting credit card rates. Card issuers do still have some freedom, though,” said Rossman. “As long as they give sufficient notice, they can raise rates on new purchases by baking in a larger margin. They can’t raise your rate on existing debt unless you’re 60-plus days late with a payment.”
The easiest way for an issuer to raise rates is to tie them to an underlying index like the prime rate, so if that index rises, the card company can pass along the increase. Most credit cards, therefore, have tied their rates to the prime rate.
How does credit card interest work?
Credit card interest is relevant only if you carry credit card debt from month to month.
“Interest rate is the daily accumulation of interest derived from the APR,” said Pendergast.
Pendergast explains how the interest rate is calculated. Divide your APR by 365, multiply that number by your daily balance, and multiply that number by the number of days in the month.
So, if your APR is 15 percent, your daily periodic rate will be $0.00041. If your current balance is $1,000, your daily interest rate will be $0.41. By the end of the month, your interest cost of $12.33 will be added to the balance of $1,000. In your monthly statement, the credit card issuer adds up all of the interest from all of the days.
What is a good APR for a credit card?
APRs vary and depend on an individual’s credit score. “The best APRs are usually in the range of 10 percent to 15 percent,” said Pendergast. He urges consumers to look for a credit card that offers 0 percent APR for the first few months to cultivate a habit of paying balances on time.
For those individuals with an excellent credit score, “mid-to-high single digits is really low for a credit card APR,” Rossman said. The Navy Federal Credit Union Platinum Card, for example, charges rates as low as 5.99 percent. The PenFed Gold Visa Card advertises an APR as low as 7.49 percent. Both of these credit cards require stellar credit scores.
Rossman noted that the average credit card APR is approximately 16 percent. “If you have lesser credit, you could easily pay 20 or 25 percent on a credit card,” he said. “Some store credit cards charge about 30 percent.”
Lowering your APR
If you have a high APR, there are ways to lower this rate. Rossman encourages consumers to lower their credit card APR by paying the balance in full.
Another alternative is to find credit cards that offer 0 percent APRs on new purchases, balance transfers or both. The cautionary note is to make certain you will be able to pay off your debt before the term expires.
A third option is to “start with the credit card you’ve had the longest and talk with your financial institution. Many times, banks and credit unions are willing to budge when it comes to APR if you’ve had a history of paying your balances on time. Most people miss out on lowering their APR simply because they don’t ask,” said Pendergast.
Lastly, since APRs are tied to credit scores, it might be a good idea to pull your current credit reports to check for accuracy.
How to avoid paying interest on your credit card
Here are a few tips to avoid paying interest on your credit cards:
- Pay your balance in full.
- Sign up for 0 percent promotions.
- Open a personal loan as a form of debt consolidation. “If you have a strong credit score, you could qualify for a rate in the 6 percent to 10 percent range. Fintech companies have made it really easy to apply for these online, and many charge rates that are lower than credit cards,” Rossman said.
- “Another method you can consider to avoid paying interest is to utilize your grace period–the time between the end of your billing cycle and when a payment is due–to its full extent. By doing this, you can avoid paying interest on a purchase for longer than what your billing cycle is. While many credit cards offer this, make sure to call your credit card company and double-check if your credit card has a grace period and that you qualify for it,” said Brian Walsh, a certified financial planner.
- Rossman added that nonprofit credit counseling can help. Organizations such as Money Management International and GreenPath Financial Wellness can provide advice and help with debt consolidation and negotiating better terms.
The bottom line
APRs and interest rates are decided by your credit history, timeliness of payments and other factors. To eliminate worries about incurring interest on your credit card, a best practice is to pay off your monthly balance consistently. When that isn’t a viable plan, consider options to lower your APR and investigate strategies to avoid paying interest altogether.